BNY Mellon

US Recession Risk Rising

We expect the Federal Reserve to raise the federal-funds target range rate by 75bp at the conclusion (Wednesday) of this week's FOMC gathering. We have revised up our terminal rate expectation from 4% (held since early 2022) to 5%. Our rationale: last week’s outsized core CPI data for August has tipped the scales towards a longer tightening cycle and even higher rates than we had been anticipating. Unless data over the next few months differs significantly from recent trends, we think that the hike we foresee this week will be matched at the Nov. 1-2 FOMC meeting. Market pricing is quite close to our own expectations. Our full FOMC preview will be published Tuesday in our weekly Short Thoughts publication.

August CPI also has more concerned about the possibility of a recession occurring in 2023. The logic is easy to follow: core inflation remains both sticky and high, and going in the wrong direction. This, in our view, requires an even more aggressive rates policy, which implies much tighter financial conditions from here. Such a tightening in financial conditions would further threaten asset prices (see below), and eventually should result in a meaningfully softer labor market and a contracting housing market – both posing threats to consumption and bringing the US closer to recession. We see the unemployment rate approaching 5% (or higher) by the end of Q2 2023, with a decline in personal consumption expenditure due to slowing labor force growth and associated cooling in wages, as Fed policy works to restrain hiring and loosens a labor market which is currently very tight.

We have been consistent in rejecting the notion that the US is currently in recession, and still do now. The labor market is still running hot, and consumption – in nominal terms – is still robust. In real terms, personal consumption expenditures through July are up 2.2% y/y, but growth in the largest category of GDP (some 70% of total spending in the US economy comes from the household) is slowing; it had been up well over 5% per year in Q1.

Our view that the US economy is not in recession has held despite two negative GDP prints. Of the six macro indicators the National Bureau of Economic Research’s considers to determine if the US has moved into recession, five have continued to rise year-to-date. We agree with the Fed that the still-robust jobs market suggests there is no recession at the moment. Initial and continuing claims continue to trend lower, and remain at levels typically seen in an expansion.

Our concerns are more long-term. Inflation’s stickiness, as evidenced by the breadth of categories within the CPI basket seeing higher prices, points to aggressive Fed policy for longer. We have often noted the need for the real federal-funds rate to rise above zero to make a meaningful dent in demand and inflation. A nominal rate of 3.25%, which we expect to see later this week, is still much too low given current inflation trends, in our view.