Inflation, policy elevate the risk of recession
In the United States, inflation has reached 40-year highs, eroding consumers’ purchasing power and driving the Federal Reserve to aggressively raise interest rates. We expect the equivalent of 12 to 14 rate hikes of 25 basis points for the full year, with the target federal funds rates landing in the 3.25%-3.75% range by year-end. We expect a terminal rate of at least 4% in 2023—higher than what we consider to be the neutral rate (2.5%) and above what’s currently being priced into the market. (The neutral rate is the theoretical rate at which monetary policy neither stimulates nor restricts an economy.)
We have downgraded expected U.S. GDP growth from about 3.5% at the start of the year to about 1.5%. The factors that led to our downgrade will likely continue through 2022—namely, tightening financial conditions, wages not keeping up with inflation, and lack of demand for U.S. exports. Labor market trends are likely to keep downward pressure on the unemployment rate through year-end, though increases in 2023 are likely as the impacts of Fed policy and slowing demand take hold. We assess the probability of recession at about 25% over the next 12 months and 65% over 24 months. We believe that a period of high inflation and stagnating growth is more likely than an economic “soft landing” of growth and unemployment rates around or above longer-term equilibrium levels (about 2% for growth and 4% for unemployment).
In the euro area, headline inflation driven by high energy prices may spike to above 10% in the third quarter. Inflation has become widespread, spurring the European Central Bank into what it expects will be a “sustained path” of interest rate increases. In September, rates will likely be out of negative territory for the first time in a decade. We forecast economic growth to be about 2% to 3% for the full year. However, Europe’s dependence on Russian natural gas and the challenges of managing monetary policy for 19 countries put the euro area at a higher risk of recession than the United States in the next 12 months. A complete cutoff from Russian gas would likely lead to rationing and recession. We assess the probability of recession around 50% over 12 months and 60% over 24 months.
China will fall far short of policymakers’ growth target of about 5.5%, given that it’s a challenge to achieve all three of their goals: the growth target, financial stability, and a zero-COVID policy. (The latter affects not just China’s economy, but the global economy as well.) We believe the actual 2022 GDP growth rate will be just above 3%, far below China’s pace for many years. Given China’s zero-COVID policy, additional outbreaks resulting in renewed lockdowns could further detract from growth. That said, recession is unlikely, with probability at 30% over 12 months and 35% over 24 months.
We recently downgraded our forecast for full-year 2022 growth in emerging markets, from about 5.5% at the start of the year to about 3%. Emerging markets continue to face headwinds from slowing growth in the United States, the euro area, and China, as well as from developed markets’ central bank tightening and from domestic and global inflation. Although higher commodities prices do benefit some emerging economies, they’re a negative in the aggregate.