The State Space: Mid-March Update

Welcome to our State Space series. Here you will find how we’re thinking about the pathways and scenarios that could take us to critical economic states. We will never settle for "it's too unlikely." We try to reason backwards from the most important (tail-risk) scenarios, their most likely pathway to fruition, and the indicators that allow us to monitor the likelihood of each pathway. Today's post is an update on what we laid out at the beginning of the month. Updates will share how these pathways are (or are not) playing out, and if new risk scenarios are potentially emerging. If you are interested in more timely and extensive access to this content, feel free to reach out to us here.

Revised Baseline: Growth has been slowing but also stabilizing around a non-recessionary outcome, but the slowdown will now take place faster due to tighter credit conditions. Inflation will still take about 12-18 months to firmly come back to pre-pandemic norms, due to an elongated lag in housing services inflation and still-unresolved goods production challenges, which are still not showing the requisite scale of relief (e.g. autos). If credit conditions tighten more nonlinearly, we would still only marginally compress our timeline for disinflation (though it would add to future downside risk in 2024 and 2025).

• We still think the US economy is slowing from elevated growth rates and would caution against getting headfaked by residual seasonality.
• The recent inflation data confirm and even exceed the scale of the inflationary bumps we warned about. Reopening-sensitive in-person services are still exerting strong pricing power, the automobile bottleneck effects remain with us, and hot rent CPI is likely to maintain and last longer than Fed forecasts. Inflation risks are substantially tilted to the upside over the next 2-3 months (we expected some of the automobile risk to already be making its way into the CPI data, but their absence so far only means that upside risks are coiling further)
• The "Dovish Hike" in March sets the stage for hawkish innovations in the future. The Fed's interest rate projections looked dovish (and were according to our scenario analysis), but their economic projections add vital context. The realized data is so strong, that the Fed's projections for a higher unemployment rate, weak GDP growth, and much lower inflation all seem to bake in a big retrenchment in bank credit. We suspect that the Fed's dimmer projections partially reflects an optical and tactical decision to avoid stoking further fears about rapid rate hikes, but not a concession about the ultimate peak for the Federal Funds Rate.
• In the absence of a credit crunch, and so long as growth looks resilient and inflation risks are elevated, the Fed is likely to keep hiking beyond their current projections. Both in 1984 and in 2006, the Fed faced similar conditions and generally continued tightening actions. We will be laying out some historical comparisons to current conditions. The risks to our baseline now tilt more firmly towards a broader credit crunch as the downside scenario, but we still do not think it is appropriate to fold a credit crunch into our baseline.

The Pathway To Inflation Risk Scenarios: Unresolved goods production challenges remain with us. We remain worried about how rising used car prices filter into other motor vehicle goods (new cars and parts) and motor vehicle services (lease, rent, repair, insurance) with a longer lag. We are seeing some potential progress on food inflation that should be of growing relevance to food services inflation, but the used car dynamic can still swamp.

The Pathway To Recessionary Scenarios: Fed shifts into a different kind of “hawkish panic” mode than the one we previously flagged, one where they continue hiking in 25bp increments, or even just holding rates, as risk premiums and banking conditions severely deteriorate. The most likely pathway to more hawkish Fed policy and recessionary outcomes still runs through the inflationary pathway. We were likely to get the hawkish panic scenario we warned about after Chair Powell's Humphrey Hawkins hearing, but it was pulled back by the bank failures that ensued just days after. Should the Fed keep hiking even while the banking system shows further deterioration, and financial markets price in higher risk premiums in anticipation of recessionary outcomes, a self-fulfilling feedback loop can emerge.

The Pathway To Dovish Scenarios: Slowing wage growth and job growth. This is probably a more underrated scenario. While Chair Powell seems keen to cite job openings as a sign of an "extremely tight" job market, the data has potential to tilt the other way sooner. We still expect bumps in quarterly wage data, but lower-tier wage measures are cooling even as participation and employment is still rising. Labor turnover rates are nearly back to pre-pandemic norms (and are more reliably predictive of wage growth trends). Job growth is also more likely to slow as we move past the residual seasonality hump in Q1. If the labor market is cooling in a non-recessionary manner, the case for the Fed tightening substantially weakens.

The Upside Scenario: Fiscal supports for labor market and fixed investment resilience. We still see the pathway for this scenario. Private sector balance sheets are still in a decent state, and fiscal supports have some scope to support manufacturing and construction activity against downside tail risks. Pockets of weakness in tech, commercial real estate, and regional banks cut against this scenario, but it is not clear that this amounts to critical mass for major macroeconomic dynamics.