Paul Diggle

Hello and welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Paul Diggle, Chief Economist at abrdn.

Luke Bartholomew

And I'm Luke Bartholomew, Senior Economist at abrdn.

Paul Diggle

And today we're talking about the state of the US economy with abrdn’s Deputy Chief Economist, James McCann. James, welcome.

James McCann

Thank you very much for having me.

Paul Diggle

So, in particular, the US economy is defying expectations and doing remarkably well. And that's despite widespread predictions of a recession amid the Fed's large rate hiking cycle. Instead, growth is resilient, and inflation has been moderating. And that's a combination, which looks a lot like a soft landing. And indeed, financial markets have moved to price a rising probability of that fairly benign outcome. So what we thought we'd do with today's episode is put forth both sides of the debate, the strongest case for why the US economy could well be defying expectations and heading towards a soft landing, but also the counter argument that this cycle still ends in a downturn over a time horizon that should matter for investors. And this really is one of the biggest debates in global macro markets at the moment.

Luke Bartholomew

Yeah, that's right, Paul. And I guess one of the most important arguments in favour of a US recession was that it was in some sense, necessary to restore price stability. The idea was that inflation had become so high and entrenched, the labour market was so tight, that the only way in which inflation could be brought back to consistent levels that the central bank was looking for was via a recession – an increase in unemployment to kill wage and price setting behaviour. But since then, we've actually seen inflation data be remarkably well-behaved. Year-on-year rates of inflation, haven't quite got back to 2% yet, the CPI measure is a little bit above 3%, and the PCE measure, which is probably the Fed’s preferred measure of inflation, is a little bit above 4%. But if you look at those on a sequential basis, or how much inflation the economy is generating, right now, those are numbers that are much closer to 2%, not quite at 2%, yet, but a significant amount of progress has been made. And what's really striking about that is that it's happened without any significant weakness in the economy, any pain from rising unemployment. In fact, if anything, activity looks like it might have accelerated recently, so perhaps what the economy is benefiting from is a very steep Phillips Curve. So, it's only taking a small increase in slack to generate a big fall and inflation pressure. And moreover that slack has been generated not by destroying jobs, which is clearly paying for an increase in unemployment, but instead destroying vacancies instead, which is a much less painful process for the economy to go through. So the thought might be that, well, we've made this much progress already on inflation, we're already extremely close to 2%, why would it need a recession to get us down to that final bit of 2% consistent inflation pressure? So James, in that context, what is the strongest argument that a recession is, in some sense, still necessary?

James McCann

Yeah, absolutely. And I think a lot of those, you know there's very clearly been a great deal of progress on the inflation front. I think the first thing to do though, is to really look at these inflation data very carefully to try and see what's going on underneath the bonnet. You mentioned the headline improvements, and really, that's been a commodities story. So energy prices, and food prices account for around 80% of the decline in CPI from its peak, and then core goods, account for the majority of the rest. There's been less of a decline in core services. And you're absolutely right, that the short-term sequential data, they do look a lot better. But we have some concerns with that. First of all, it's over a relatively short period of time. Secondly, when we look at those sort of core services, excluding housing indicators that people are most focused on, because they think gives the best reading of where domestic price pressures are setting up. Then actually, we think there hasn't been quite as much progress, especially when we exclude a couple of the more volatile components there. So health insurance prices in the CPI measure have been plummeting. And that's just because of a methodological change that the BLS has made. We've seen airfares fall by 16% in aggregate over the summer, which looks like a pretty extraordinary thing. It might be related to jet fuel prices. But also we know that there's been a lot of volatility and airfare pricing post-pandemic and particularly around the seasonal adjustments of those so I think we're a little bit more sceptical and a way of putting it might be the death of inflation, maybe slightly exaggerated, albeit I'd certainly concede there's been progress there. So we're still a little bit concerned that we think underlying inflation is probably still running a good bit in excess of the Fed’s target. And then I think your second point sort of trying to explain how has this happened painlessly is an important one. And when we look at the sort of natural drivers of US inflation through the labour cost dynamic, we still think that those labour costs are running too strong - still well in excess of the inflation target when we try and account for productivity too. So we were not fully convinced therefore that benign disinflation has taken place, we still think a further adjustment is needed. And it's a good question to say can that continue to be painless? You know, historically, that's not been the case. But this has been an unusual period. So I think we have to keep an open mind from that perspective. But I still would urge that there's a good amount of work to be done before we get to this target. And we're not there yet, even though some of the short-term inflation prints maybe feel a little bit that way.

Paul Diggle

So regardless of whether or not recession is necessary to tame inflation, another part of the case has been that the Fed’s tightening has already been sufficient to generate a downturn. So necessity or otherwise aside, the damage could have already been done by 525 basis points of rate hikes working its way through the system. But I suppose the remarkable resilience of the US economy over the past year could well suggest actually, is not sufficient to generate a downturn. And in particular, this resilience is manifest in composite PMIs above 50, nowcasts which track near-term growth suggesting that Q3 US GDP growth could come in very strong. And this resilience has been driven by consumer and business balance sheets – i.e. the finances of households, and corporates are just in pretty good shape. So households came out of the pandemic with enormous overhangs of savings. By our estimates, James, they were as much as 10% of GDP above what's normal. Aggregate debt loads of households are actually fairly low after years of post-financial crisis deleveraging. 30-year mortgage, fixed mortgage rates, of course, also attenuate some of the pass-through of higher interest rates. And then on the corporate side, debt loads are actually quite high. But it does appear that business borrowing has been termed out on to kind of longer-term lower rates. So that means that there hasn't been as much of the pass-through of higher interest rates. At the same time, high earnings growth amid a high inflation environment’s actually helped corporates. So that means that the ratio of corporate interest payments as a share of profits has actually fallen back, even as interest rates have gone up. And then perhaps the final thing that would bolster the case for a soft landing is that one could argue that the peak pass-through of higher interest rates has actually already passed. So ordinarily, we think of monetary policy as having long and variable lags. But the trough and actually turn around in the most interest rate sensitive sectors of the US economy, things like housing and business investment, could mean that we're already through, out the other side of the peak tightening in policy rates in terms of its pass-through to the economy. So that's, that's the kind of strongest case for actually, it's the tightening so far, won't inevitably lead to recession. But on the other hand, James, there are signs of weakness. There are certain indicators you can point to, which really are quite weak. So what's the strongest case that actually the Fed’s actions are enough to get this downturn in motion?

James McCann

Well, I think the first thing, I think you set out the case very strongly there on why the economy has been much more resilient than we expected. And I think forecasters in general probably have to eat a little bit of a humble pie this year, given that tightening cycle and the lack of a growth slowdown, I guess, making the case that there will be a biting policy, and we will see weaker growth and that will eventually culminate in a downturn, we maybe have to look at some of that ballast and say, is it something that we think is a permanent feature of the economy? Or is it something that we think will be eroded over time? And I think I probably fall into the latter camp at the moment. So if we take the consumer dynamic, which I think has been really critical, particularly in this recent upswing in activity, which has led to tracking estimates of GDP for the third quarter you know above 5% annualised. Consumers are still very heavily drawing down on their post-pandemic savings. You know, what's been extraordinary is that those drawdowns accelerated over the course of this summer. So, it's absolutely the case that consumers are spending money, and they have the firepower to do so because they can tap those buffers. We still think, though, that those are finite. And when we try and cut the numbers, both from trying to estimate those savings, like you mentioned and then cross-checking that by looking at the financial accounts, looking at checking account balances, for US households, it does look like they will eat very significantly into those by the end of this year. So we are not convinced that consumers can continue to defy gravity and spend at this clip, given the fact that those savings will eventually start to run dry. And we know that the dispersion of their savings is obviously very uneven, so I imagine lower-income households are already meeting the limits of that firepower. And then on the corporate side, corporates have been shielded through the term structure of their debt from higher interest rates. When we look at the redemption profile for corporates, then certainly, it does look like they're going to have to increasingly roll on to higher interest rates, particularly for high-yield companies that will look pretty steep. So I think there'll be more of a bite from policy there. And both households and corporates are also operating in an environment of very, very tight bank lending standards too. We've seen the tightening in the Senior Loan Officer survey, we know that typically instigates quite a sharp credit crunch. Again, perhaps that credit crunch is happening a little later, because of the strong balance sheet position of the private sector. And then if we look at a range of other indicators, maybe they're not quite as rosy as some of the hard activity data that we are seeing. You mentioned some tentative rise in delinquencies maybe hints of some distress creeping into aspects of the household sector. We know the Conference Board’s leading economic indicator is very much in line with what we'd normally expect to see across those measures for a recession to be to be on its way. Private sector surveys are pointing actually towards a weaker end to the year in terms of activity. We have seen a steady deterioration in those. We know the corporate profitability has been under a degree of pressure and margins are coming under pressure. They’re classic sort of late-cycle dynamics as well. So, when we try and cut these and balance these dynamics, you know, certainly I think we have to be very conscious that the economy has been much more resilient this year. But I think when we forecast forward, we, we are cognizant that we think 5% plus policy rates are tight. We do expect that tightening to have an effect on activity. We might think it'll be nonlinear through the economy. So maybe it has already affected the most interest rate sensitive sectors of activity so far, but we think the bulk of the tightening is still to come. And that's why on balance and it has become a tighter call, we still do think a downturn is probably more likely, albeit coming a little later, in 2024.

Luke Bartholomew

So another interesting aspect of this debate, another reason it can be very difficult to tell whether we're heading for a hard or a soft landing, is that in real-time at least for a while, those two states might feel very similar, in the sense that they both presumably involve a slowing in activity and inflation. It's just that in the soft landing, it stabilises at a lower expansionary level, but in a hard landing, that slowdown continues. But as this is sort of unfolding, and you're seeing the data come in, they can feel very, very similar. Alternatively, I guess there is another transition path into a recession. So rather than this sort of slowing down, slowing down, and eventually you tip in, you could imagine the economy goes through for want of a better phrase, something like a wily coyote moment where the economy so to speak comes off the edge of the cliff, it takes a while for gravity to catch up, but eventually gravity does catch up, and it falls extremely rapidly. So, to translate that, in economic terms, what I'd be imagining there is that we see a quarter perhaps of extremely strong growth, and then it just tips very, very quickly into contraction rather than a slowing to below trend growth and then sort of falling slowly into recession. So of those two transition paths, what do you think is a more plausible way for us to end up in recession?

James McCann

Yeah, I mean, this reminds me of that famous quote that ‘things take longer to happen in economics than you think they will, and then they happen faster than you thought they could’. And you know I think it could almost happen either way. A good example is payrolls came out, as we record this, I guess, this morning. We have seen, you know, a deceleration very clearly in private-sector hiring. That's halved from the pace that we'd seen at the start of the year. In many ways, that's a good thing. That’s exactly what you want to see as part of the soft landing, but it's hard to disentangle if that's just part of an ongoing slowdown that will culminate in much more distressed payrolls reports, which are telling us much weaker aspects of, you know, weaker signals about what the, what the economy is doing. You know, and similarly, when we look at things like the jobs survey, the big decline in openings, is very clearly a positive sign. But we know that openings are probably the aspect of the employment demand adjust first, because it takes longer then for businesses to slow hiring decisions, and then to adjust their own workforce too, similar to hours worked, which has been weaker this year - around 1% annualised over the last six months. So it's possible that all these indicators are giving us a sense of comfort at the moment, they're consistent with a soft landing. But actually beneath the surface, they're the early stages of a downturn, and we won't know that downturn is actually coming until later. And that downturn might be quite sudden. I know, I know that both of you, Paul and Luke have written on ‘stall speed’ yourselves. And I guess that dynamic whereby an economy reaches a tipping point, once activity slows to a certain point, I'm not sure if that will be something that's relevant around this.

Paul Diggle

Yeah, so we did a research project a couple of years ago, looking at stall speed dynamics in the history of GDP data and economic cycles, and our finding there was that economies do often stall into recession. So slowdowns can become kind of self-fulfilling, such that actually, what looks for a while just like a modest slowdown in growth can actually just continue to the point where growth is actually just straight up negative, i.e. the economy's in recession. So that would be kind of Luke's first transition path, I suppose. But James, is it plausible that the loosening in labour market conditions which so far has been very benignly felt via a fall in job vacancies, i.e. fewer openings are being advertised, that's how the labour market is loosening, rather than more painfully through actual rise in unemployment? Can that continue? And I have in mind here, you know, what we economists were technical Beverage Curve loops, as one way in which actually a period of declining vacancies in time gives way to rising unemployment.

James McCann

I mean, you're absolutely right there. What we've seen has been pretty extraordinary. It's this decline in openings, as I mentioned, would often be seen as a precursor to weaker unemployment or rising unemployment dynamics. So that's what generates these loops, where you get sort of the movement where openings increase first, but then unemployment increases. And you're not to get too technical, but you slide along a Beveridge Curve. I think, post-pandemic we saw a big shift higher in opening sort of a structural shift higher or what looked like a structural shift higher, I think part of the decline maybe has been a reverse of that. So it's the economy, maybe healing from the pandemic, figuring out some of those matching issues that had between employers and workers. And maybe there has been a large aspect of that decline in openings, which has been benign. But historically, when we do look, it is unusual to see openings fall very significantly without any effect on the labour market. Normally, we tend to see those feed-through effects between three to six months. So we would expect if there is, if this decline in openings is going to cause economic distress, that to start showing up relatively soon. So we'll certainly be watching very closely. Obviously, we got a pop in the unemployment rates as well, this morning, but that looks to be more a participation story at this stage. I'm not seeing that as a sign of labour market distress necessarily. But you know, it's absolutely possible again, just going back to this initial theme, that some of the seeming soft landing-esque tone to the data is actually an element or it contains within it those normal economic dynamics, which are sort of setting the stage for the early stages of a downturn.

Paul Diggle

So what does that mean for timings, then, in terms of the point at which actually growth could turn negative? You know we're just about in the camp of it being recession in the end. When do we think that could that could hit?

James McCann

Absolutely, I think a recession this year now looks really, really unlikely, just based on the current run rate of data through Q3. It's possible, we do get that moment where the economy falls off a cliff into Q4, but even the leading indicators aren't necessarily signalling that at the moment. We've pushed it, or I guess our expectation is it might shift back a little further into mid-2024. So probably pushing back our expectation in total by around six months or so. That would allow a greater time for some of these balance sheets support, be it from the consumer or from low fixed business interest rate lending, to start filtering out and for them to feel the bite more I think from from tighter policy settings and for all those cyclical downswing dynamics to really start kicking in. That will be consistent with the messages from our recession probability models, which have actually started to show short-term recession risks declining, likely off the back both of some of those short-term data dynamics, which seem to have improved a little if anything and some of the more benign messages from financial markets, too. But those signals still are longer term, let’s say 9 to 12 months horizon, they’re still that the economy is in a degree of trouble and a downturn is still relatively likely. So that's why we sort of feel that mid-2024 feels about an appropriate point to put a recession into our base case, you know, albeit with a caveat, as we've mentioned, and I think this discussion illustrates well, that this is, you know, a really close call and getting these timings, let alone the direction is very challenging at the moment.

Luke Bartholomew

I think that's exactly right, James. This has become a very close call, I think what our discussion brings out and the way in which the data has evolved over the last six months or so is that the path to soft landing has widened somewhat, what seemed like, you know, a pretty remote upside scenario at one point, that the Fed would be able to pull this thing off, does seem to have increased in probability. And I guess that's kudos to the Fed in some extent, they've actually managed to get us even to this point. And I suppose the closeness of those two scenarios does go some way to showing the importance of thinking through the uncertainties facing the world in terms of different scenarios. Certainly, that is what the market has to price across a broad risk distribution. And that's how we think about the outlook as well. And I guess we will see how it evolves over the rest of this year into next year, whether we have that cliff moment or not. But at least for this week, that is all that we have time for. So may I please remind you to subscribe and rate us on your podcast platform of choice. And then all that remains is for me to thank James, for joining us today and his excellent thoughts and to thank you all for listening. So thanks very much and speak again soon.

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