The writer is president of Queens’ College, Cambridge and an advisor to Allianz and Gramercy
You would think that after the chastisement brought by last year’s transitory inflation call, consensus forecasters would be more open-minded in how they describe the US recession they see coming in 2023. .
Yet they confidently assert that this recession will be “short and shallow” and again encourage us to “look through” a major development. I’m afraid this is a repeat of the analytical and behavioral pitfalls that featured in last year’s ill-fated inflation call and the consequences of which we have yet to put behind us.
Let me stress up front that this column is not about me predicting a recession. Indeed, while I consider the risk to be uncomfortably high, I am not convinced that this is a done deal as many have predicted. Nor do I foresee what such a recession might look like. Rather, I am writing to warn you of the pitfalls that undermine the latest consensus forecasts.
Without a doubt, the “short and shallow” call has some advantages. The labor market is strong, with still significant vacancies acting as shock absorbers that insulate jobs from lower growth. Private sector balance sheets are relatively strong, with a still high stock of savings protecting household consumption, cash-based businesses and debt maturities that have already expired. And the banking system is less likely to act pro-cyclically given its strong balance sheets, better net incomes due to more favorable interest margins and limited corporate defaults.
All this suggests that the private sector will not be the amplifier and prolonger of a recession. Some argue that the same can be said of the public sector, as a rapidly falling inflation rate would allow the Federal Reserve to downgrade and then suspend its rate hikes. Meanwhile, significant fiscal austerity to tackle high public debt is ruled out by a divided Congress.
These are all valid arguments. But they are not deterministic. What is true for the economy as a whole is far from being true for the population as a whole. The most vulnerable people and businesses have already depleted their savings, face more limited income opportunities and have less access to low-cost credit. Their negative impact on growth is not easily offset by the better off.
As inflation eases over the next few months, we are likely to see rate stickiness of around 4%. There are many reasons for this, from wages to the changing nature of globalization, to the multi-year impact of rewiring supply chains and the energy transition. This is a tricky situation for the Fed. It is compounded by the fact that it is not just about managing a short-term growth/inflation dilemma, made more uncertain by the lagged effects of massive interest rate hikes and money supply contraction. The Fed faces a trilemma involving financial stability as well.
Although fiscal policy will not turn sharply toward austerity in an absolute sense, it will be restrictive in relative terms. Finance will be similarly affected – banks’ lending caution will likely be amplified by the squeeze on liquidity and greater risk aversion among non-banks.
Then there is the overall angle. The United States is not the only major economy facing slowing growth. Europe is already in recession and China remains held back by its zero-Covid policy. Then there is Japan’s difficult exit from yield curve control. All this at a time when growth models need a major overhaul.
Such simultaneous growth contractions open the door to vicious feedback loops, emphasizing the need for greater humility to predict what lies ahead. The same goes for behavioral considerations.
When we are taken out of our comfort zone by disturbing news, our biases often kick in to make the news less disturbing. Last year’s version for consensus forecasters was “yes, we have high inflation but don’t worry, it’s transitory”. This year’s version is “yes, we are facing a recession but don’t worry, it will be short and superficial”.
Both analytical and behavioral factors suggest that we should be cautious about appealing to “short and superficial” consensus. Businesses, governments, households and equity investors should plan for a range of possible outcomes, with no one dominating as a baseline. Such fluidity calls for guarding as much as possible against policy errors, corporate missteps and market crashes.
Scenario planning for a wider range of possible outcomes is hard and time-consuming work, and much of it will end up being redundant. Betting on a flimsy consensus forecast, however, could prove far more damaging.