Weighing the Risks of Inflation, Recession, and Stagflation in the U.S. Economy
Harvard Business Review | by Philipp Carlsoson-Szlezak, Paul Swartz and Martin Reeves | June 10, 2022
It’s easy to point to the U.S. economy’s vulnerabilities: Despite the strong labor market and strong household balance sheets, consumer confidence has been depressed for a while, likely driven by energy prices. Deteriorating business sentiment can weigh on investment rapidly, robbing the economy of momentum. But the greatest risk for a recession is monetary policy makers, who in trying to moderate inflation have pushed up the risk of a recession. The authors offer four priorities for executives to focus on while navigating the macroeconomic risks.
The macroeconomic outlook continues to dominate the executive agenda. Last year, when demand overshot and supply chains sputtered, many firms discovered pricing power they never experienced before.
But the Fed’s battle against resulting inflation has pushed up the risk of recession. Today, macroeconomic fears are rotating out of inflation and towards another downturn. While the idea that a recession would put out the fire of inflation is persuasive, it is not guaranteed.
As we wrote here in March, monetary policy makers pose the greatest risk of a U.S. recession. In fighting inflation, they risk pushing down growth. Hike rates too fast, or too far, and they deliver a recession. Pulling off a “soft landing” is hard.
Since March, this delicate balance has only grown more precarious. The economy, though robust, is decelerating, while inflation is likely peaking. Against such easing pressures, the Federal Reserve’s rate path as priced in markets has grown more aggressive. In mid-March the expectation was the Fed would raise interest rates to near 2% by February 2023; now the expectation is close to 3%. Even if the Fed were to change plans, these expectations have driven up long-term rates. Stock markets, especially the tech sector, have seen steep declines as a result, putting further pressure on the economy.
Is the policy error already done and a recession on the way? Though we continue to view this as an unlikely scenario in 2022, the odds of a soft landing in 2023 are getting longer. To understand why, we need to look at the path of inflation as well as the impact of higher rates on the economy.
Inflation Is Likely Peaking
Covid inflation has been an unusual confluence of extremely high demand, driven by enormous stimulus, and simultaneous supply bottlenecks in product, commodity, and labor markets. It was more persistent than widely expected because new shocks kept coming. Initially, it was harmless “bounce” inflation from low prices at the start of the pandemic. Later came the supply bottlenecks; then the energy surge of last year; an enormous scramble for labor; the unexpected war in Ukraine; and the economic lockdown in China this spring. Inflation will remain hard to predict — those who warned against inflation early did not do so because they anticipated this sequence of shocks.
While it’s not over, the period of maximum stress is likely behind us. Demand is cooling. Inventories have been rebuilding healthily. Workers are returning to the labor force. This will allow inflation figures to moderate throughout the rest of the year.
Another signal of moderating inflation is firms’ waning pricing power. Firm profits grew strongly in 2021 — microeconomic proof of inflation since firms were clearly able to pass through price pressures to consumers. But that is less and less likely to persist. Consider that firms usually face a tradeoff between raising prices and losing market share. As the economy reopened, that tradeoff was suspended because of high demand and low supply. But as demand slows and inventories rebuild, pricing power is likely to wane. Big retailers, such as Walmart and Target, recently exhibited such dynamics when they showed shrinking margins.
That said, moderating inflation is not the same as vanquishing inflation. Realistically, inflation, while declining, will stay above the target rate of 2% through all of next year and plausibly beyond — and upside risks remain. There could be new, unexpected shocks.
Monetary Policy is Getting Tough
Though most of the Fed’s rate hikes will come this year, their lagging effects will shift recession risks more into 2023. On current trajectory, the policy rate will reach a “tight” level of around 3%, and the headwinds to the economy will persist.
But this may not be the end of monetary tightening. For monetary policy to declare victory, price growth has to return to its pre-pandemic levels (and policy target) of around 2%. As the drivers of inflation are rotating out of idiosyncratic squeezes, such as auto supply chains, and into more sticky areas, such as services more broadly, rates may have to climb further.
The headwind to the economy is already being felt. The expectation of tighter policy has shifted up longer-term interest rates, which have battered equity markets — and in turn, household wealth and confidence — and slowed spending growth. Sharply higher mortgage rates are impacting the housing market.
All this headwind is enacted by policy makers without surgical precision. In fact, central bankers are flying virtually blind, only viewing the economy through a hazy rearview mirror, as most macro data are lagging. It’s uncertain how much their decisions will tighten financial conditions or how much that impacts the economy — and all of this could change abruptly. Thus, while rate hikes are a necessity given high price growth, how many and when is virtually unknowable.
How Soft – or Hard – Could the Landing Be?
As the chance of recession comes down to the balance of moderating inflation vs. a slowing economy, we should also ask how much stress the economy can absorb.
If a 2023 recession is avoided, it will be because U.S. consumers and firms are still in robust health. Household balance sheets are strong, and the labor market is booming. Encouragingly, we see some cooling of inflation pressures (such as falling durable goods prices and easing wage growth) without macroeconomic weakness. And though firms’ margins will decline from here, they’re coming down from exceedingly strong levels.
Yet, it’s easy to point to the economy’s vulnerabilities. Deteriorating business sentiment can weigh on investment rapidly, robbing the economy of momentum. And despite the strong labor market and strong household balance sheets, consumer confidence has been depressed for a while, likely driven by energy prices. Add to that the fact that wobbly financial markets shrink household wealth — a problem that would get bigger if the housing market were to turn — and the cycle looks vulnerable.
That said, if a recession hits in 2023, there are good reasons to expect it to be mild because the drivers of the most damaging types of recession are less likely today. Banks are well capitalized, profitable, and unlikely to drive a structural overhang in recession. This leaves the prospect that demand could return quickly and that labor markets remain tight, which would keep a recession mild.
Fears of True “Stagflation” Are Premature
One benefit of a recession would be the prospect of putting out the inflation fire. But what if a recession fails to reset price growth to its pre-pandemic slumber? A recession in 2023 or 2024 could easily coexist with above-target (2%) inflation, even if current levels are implausible. Such inflation could have sustained drivers, such as wages and housing, as opposed to the idiosyncratic squeezes we’ve seen so far.
Though a plausible risk, such an outcome would still not be the true “stagflation” of the 1970s. Though popular in the headlines today, stagflation is more than the coexistence of too slow growth and too high inflation. That era was a structurally broken economy, one where price growth never calmed because the trust (expectations) in price stability was deeply damaged. This delivered high long-term interest rates, hampered monetary and fiscal policy, and sustained elevated unemployment rates — a constellation of outcomes that is much worse than prospects of elevated inflation and slow growth.
Such a nightmare scenario cannot be ruled out today, but it should not be the base case. What stands between a recession with above-target inflation and “stagflation” is the Fed. If the central bank has the resolve to keep monetary policy tight despite recession, there is every chance that inflation can be wrought from the system. That requires significant strength and independence, as politicians, investors, and the public would push for rate cuts. Yet faced with the possibility of structural break we still think the Fed would stand tall.
What Executives Should Do
Digesting the risks, executives need to focus on four priorities:
First, think about pricing strategically. Though inflation is set to moderate, it will do so slowly. Risk will remain to the upside, even in a recession. While the power to pass price increases will be moderated relative to the Covid recovery, lingering price dispersion and volatility will ensure selective opportunities for some plays in some markets.
Second, avoid a binary framing of recession and avoid mental models anchoring the risk on recent experiences. Not all recessions are deep structural scars such as 2008, and not all are as severe in impact as the Covid recession. Understanding the drivers and nature of future recession will set firms up for better navigation. Don’t discount the idea that the next recession could be mild and short.
Third, don’t forget that every dislocation and stress is also an opportunity for outperformance. Those with a playbook centered on resilience and controlled risk-taking stand a chance of relative, or even absolute outperformance if they can create and seize strategic opportunities in bad times.
Fourth, while tech stocks multiples have fallen sharply, don’t conflate a funding squeeze and market correction with a decrease in the strategic importance of technology. The application of digital technology will continue to drive competitive disruption and growth across all sectors.
In short, while we can be clear on drivers and risks, uncertainty and change will require that companies regularly update their view of the economy, prepare for multiple plausible scenarios, and avoid assuming the worst outcomes.
[Editor’s Note 6/10/22: This piece was updated following the release of the May Consumer Price Index.]
Source: Weighing the Risks of Inflation, Recession, and Stagflation in the U.S. Economy (hbr.org)
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