Oren Klachkin, lead US economist, and Ryan Sweet, chief US economist at Oxford Economics discuss what they are thinking about for Q2.
Q1: What real-time data are you tracking to monitor banking sector stress and its economic impact?
A: To assess current conditions and contagion risks, we are tracking regional bank stock prices, creditdefault swaps on large banks, bank liquidity needs, deposit and money market fund flows and borrowing through the Fed’s discount window and their new Bank Term Funding Program (BTFP).
Deposit outflows from banks and inflows to money market funds have decelerated recently. Banks are tapping the Fed’s discount window, though at a slower rate, while use of the Fed’s BTFP has also moderated. Meanwhile, credit default swaps on large banks haven’t surged, suggesting last month's turmoil was a temporary tremble and not a precursor to a banking crisis.
Q2: Which businesses will face the greatest strains during the anticipated mild recession in H2?
A: Firms in the business-to-business space will struggle more than those who sell to consumers. Businesses normally cut back quickly and significantly on expenses during recessions as they seek to protect their profit margins as revenues fall. Consumers also retrench, though largely on discretionary items (around 25% of aggregate consumer spending). Business investment has historically declined ahead of a recession and suffered larger losses than consumer spending during a downturn.
Businesses who derive their revenue from spending on goods will face the greatest challenges, as these outlays tend to decline more than services. We anticipate that the severest challenges will generally be in the segments tied to spending on big-ticket goods items that are purchased via financing, as banks tighten the flow of credit to consumers and businesses and interest rates hold well above their pre-pandemic levels. We'll be paying close attention to developments in the housing, technology, and automotive sectors. We will also be keeping an eye on developments in financial services, given last month's banking system stress.
Q3: Inflation is running hot because labor demand remains strong. What will it take to cool the labor market?
A: The Fed needs trend job growth at or below 100k/month and wage inflation to ease to 3.5% y/y. Both are currently running well above these targets, with employment rising 345k on a three-month moving average basis in March and wage growth up 5% y/y.
We expect a mild recession in H2 2023 and a tightening in credit conditions because of the recent issues in the banking system. This will help cool GDP, employment, and wage growth – as long as broader financial market conditions don't ease. The softer job market and slower nominal wage growth will put downward pressure on inflation, albeit over time. Super core inflation – core services excluding housing – is driven by the strength of the labor market, primarily nominal wage growth.
Q4: Markets are calling for rate cuts later this year but you expect a pause. Why are they wrong?
A: We believe financial markets are pricing in Fed rate cuts for later this year because they anticipate a relatively more significant deceleration in inflation. Market-based measures of inflation expectations, such as the 5- and 10-year breakeven inflation rates, have trended lower since early 2022.
We believe investors are likely viewing the recent slowdown in nominal wage growth as a sign that super core services inflation (services inflation excluding energy and shelter) will decelerate at a faster clip. We believe the Fed will keep rates higher for longer to ensure inflation is clearly moving back to the 2% objective.
The current environment is the first time since the late 1970s and early 1980s that the Fed has had to grapple with high inflation and the potential for a recession, and the policy path from then is likely feeding into investors' expectations of rate cuts in H2 2023. Recall, the Fed pivoted and cut rates in 1980 because of a rise in unemployment. However, the Fed then needed to quickly reverse course and resume tightening monetary policy, which triggered a double-dip recession. The Fed is well aware of this and will want to avoid its past errors, and so we expect them to hold for longer than markets anticipate.
Q5: What’s your outlook for the housing market?
A: Relative to other forecasts, we're more sanguine on the housing market's prospects this year and next. The moderate rebalancing between demand and supply is expected to engender healthier housing market conditions, but we don't think a major downturn is likely.
Early 2023 showed that the housing market has started to reach a bottom, and while more pain may lie ahead as lending standards tighten and construction costs stay high, we don't see significant downside risks. We expect a relatively modest peak-to-trough decline of 6% in national house prices. Supply-demand dynamics will keep a floor under house prices, and while the inventory of existing homes for sale has increased, it remains low by historical standards as would-be sellers stay on the sidelines.
Most homeowners have mortgages below the current 30-year fixed rate, so have little incentive to sell. Recent drops in house prices and mortgage rates have led to an increase in mortgage purchase applications and more pending home sales, showing even a small boost in affordability will bring buyers back .
