While the case for a recession today is not nearly as obvious as it was ahead of the COVID-19 recession two years ago, the reality is that chances of dipping into at least a mild one in the coming year or so are unfortunately higher than we would like. This is resulting from the ongoing inflation problem and the monetary tightening that will be needed to resolve it. Yet, this outcome is still not something that is showing up in the most recent hard economic data. Chart 1 in our report, for example, shows two recession probability gauges from the Fed: one is based on the yield curve, which has re-steepened, and the other is based on real economic data, which is still very solid. Both still show extremely low probabilities of recession: 0.2% and 3.2%, respectively. Furthermore, in the latest Blue Chip survey of professional economists, when asked to estimate the probability of a recession in 2022 and 2023, the respondents felt the chances were much higher, but still only 26% and 39%, respectively—this is only a little higher than the probability of having one in any given year.
Economist Milton Friedman theorized that the impact from monetary policy operates with “long and variable lags,” which is usually taken to mean roughly 9-18 months. As a result, and almost by definition, the deeper we get into the tightening cycle and the tighter financial conditions get, the greater the probability of recession becomes. Hence, given the Fed’s more aggressive forward guidance, and the stickier nature of the current inflation problem, it is hardly surprising that financial market participants have been getting closer to fully pricing one in—even before almost any hint of a slowdown has actually started to appear in the hard economic data.
Similarly, the latest corporate earnings data—which tends to lead the economic cycle by around a year—still looks fairly robust. Yet, if we are heading for a recession that will certainly change, bringing with it the risk that any actual earnings weakness will place even further pressure on market prices, or at least help to act as an anchor against any quick market rebound.
With weaker earnings growth the next potential hurdle for market participants, in this Economics Weekly, we look at both the current earnings picture and what has happened to earnings during past economic downturns, as well as what happens if inflation truly is now structurally higher.
For a copy of this report or to subscribe to the Economics Weekly or Economic Indicators reports, please contact your William Blair representative.
Richard de Chazal, CFA, is a London-based macroeconomist covering the U.S. economy and financial markets.