INVESTMENTS UPDATE

Three reasons why the chances of a US recession are high

  • Keith Wade
  • 30 May 2022
  • 5 minute reading time

The US central bank, the Federal Reserve (Fed), has raised its target interest rate by 0.5% to a range of 0.75% to 1%. US inflation hit a four decade high of 8.5% in March, and fell only slightly to stand at 8.3% in April. Investors now fear the Fed may continue to raise rates as a means to potentially reduce inflation and that this could dampen economic growth and lead to a US recession.

For my part, I do indeed expect the Fed to continue raising interest rates. In fact, our analysis suggests a recession may be a necessary trade-off in order to potentially bring inflation down.

I believe that, to achieve a hoped for economic soft landing, interest rate rises would need to be implemented gradually. Hopefully, this could lead the economic growth rate to slow rather than turn negative. But if it does turn negative, we could see a recession, with economic output falling and unemployment rising rapidly. However, raising interest rates while keeping economic growth positive can be a difficult thing to achieve.

This month’s 0.5% interest rate rise is the largest increase since 2000. The recessions of the 1980s and 1990s followed similar inflation increases to that being experienced today. While there was much talk of achieving a soft landing during these periods, this was not achieved.

In my view, there are three reasons why the chances of a US recession are currently high.

1. Inflation is becoming entrenched

Inflation is high, with high prices being seen across a broad range of consumer goods, at a time of low unemployment. In this situation, wage rises could accelerate significantly which, in turn, could lead to further price rises and continued inflation. As a result, the Fed may need to increase interest rates further to bring down inflation, which could lead to a recession.

2. Interest rate policy is a blunt tool

Interest rate changes can face long and variable lags before they have an economic impact. Moreover, central banks can be tempted to keep raising rates up to the point where the economy becomes damaged, as was the pattern in the 1980s and 1990s. Confidence also plays a role: fears of recession can lead people to cut back on spending, which can, in turn, lead to an actual recession.

3. Interest rate policy is made more complex today by what is happening elsewhere

  • Interest rates are set to rise around the world in response to inflation, not just in the US. Global trade will be weaker as a result.

  • Activity in Europe is significantly affected by the war in Ukraine and ongoing efforts to ban Russian energy. The consequent rise in commodity prices reduces real incomes and spending around the world.

  • China is not raising interest rates, but its zero tolerance towards COVID-19 is damaging its economy.

  • Government spending is falling across the world, after the massive support during COVID-19 lockdowns.

So the task of achieving a soft economic landing seems particularly challenging at present. I believe interest rates will still rise, as they are starting from low levels. I expect six further consecutive interest rate rises from the Fed, with the target interest rate peaking at 2.75% to 3% in early 2023.

Some investors expect greater interest rises than I do. But, given the current economic challenges, even my more modest forecast rises could be sufficient to damage the US economy. I believe inflation will come under control, but the price will likely be a recession.

Keith Wade is Chief Economist at Schroders

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