By David W. Berson, Ph.D.
Before the events of the past week (Silicon Valley Bank (SIVB), Signature Bank (SBNY), etc.), my view of the most likely course for the economy was as follows:
- Continued modest economic growth into about mid-year.
- Inflation trending lower this year, but remaining above the Fed’s 2.0 percent long-term goal.
- The Fed tightening further in response to above-goal inflation, bringing the federal funds rate target range up to 6.00-6.25 percent, with a further inversion of the already significantly inverted yield curve.
- A recession (probably on the modest side) starting in the second half of this year and persisting to the end of 2023 or into early 2024 (depending upon when it actually starts).
- Fed easing in 2024 as prior monetary policy tightening and recession combine to bring inflation back to around the Fed’s goal.
- The yield curve turning positive again in the first half of 2024.
But the recent disarray in the banking system (as seen with the failure and takeover of SVB and Signature) appears to have caused fundamental changes to the near-term course of the economy. Inflation remains above target and the economy is still growing (with the Atlanta Fed’s GDPNow estimate of real GDP growth for the first quarter at 3.2 percent as this is being written), but there are now heightened concerns about the stability of the financial system and the sustainability of the current expansion.
Economists look closely at the shape of the yield curve and note that recession risks climb when it is inverted significantly for an extended period of time – conditions that recently have been met. Why has the inverted yield curve been such a good leading indicator of economic downturns? In large part, this is due to the behavior of depository institutions, borrowing short (through deposits) and lending long (through loans or the purchase of longer-term securities). This usually works well with an upward-sloping yield curve, but when it inverts (with yields on short-term fixed-income securities moving above those for long-term securities), banks may take losses when selling longer-dated assets. At a minimum, bank capital can take a hit in this situation and spreads between assets and liabilities for banks are reduced (or become negative) – reducing the incentive for banks to lend, thereby slowing economic activity. And enough of a decline in lending usually results in a recession. With SVB and Signature, the impacts of an inverted yield curve are clear (along with apparently poor risk management practices on the part of those institutions). Given current financial conditions, other banks are likely to pull back.
This is likely to result in the following:
- The expected recession is now more likely and will probably occur sooner (not immediately, but perhaps by mid-year).
- The downturn may be more severe than previously expected, given the stresses in the banking system.
- As the economy slows sooner, inflation may move lower sooner, as well. Certainly, a deeper economic downturn is likely to bring inflation down by more.
- Given this outlook, the Fed is likely to tighten only one more time, at the March 21-22 FOMC meeting. It is certainly possible that there will be no tightening at that meeting, but given still rapid inflation and continued economic growth, a 25-basis-point move is more likely. But that’s probably all the tightening that the Fed will do in this cycle. As a result, the peak fed funds rate will either be at the current 4.50-4.75 percent range, or slightly higher at 4.75-5.00 percent. It’s basically a coin flip at this point.
- With a downturn starting sooner than previously expected (and perhaps being more severe, as well) and inflation moving lower more quickly, the odds of Fed easing later this year are meaningful.
We see three most likely scenarios as a result of all this:
- Baseline scenario: The 2023 recession ends by the start of next year, with a lower level of interest rates and a positively shaped yield curve. The end of the downturn should result in a solid year for economic growth in 2024, with lower inflation near the Fed’s long-term goal. This would be a positive result for equity markets next year. Subjective probability: 60 percent.
- Down scenario: The recession is more severe than expected, given banking system stress. The Fed is forced to ease sharply as a result, but inflation falls significantly by early next year. Economic growth should resume by the middle of 2024. While this is a negative scenario for equity markets in the near term, it is very positive once the economy starts to grow again. Subjective probability: 30 percent.
- Really bad scenario: It’s the 1970s all over again! The Fed is forced to ease sharply in response to recession and banking system problems, but while inflation moves lower, it never gets close to the Fed’s long-term goal before Fed easing, and the pickup in the economy boosts inflation again later next year. Subjective probability: 10 percent.
Conditions are very fluid currently and there are other possible scenarios, but these are the most likely right now.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.