News in Charts: The economy’s Jekyll and Hyde moment

In Fathom’s Global Outlook, Spring 2023, finalised in early March shortly before the failure of Silicon Valley Bank, we labelled our single most likely scenario ‘Recession postponed’. With the latest macroeconomic data much stronger than one might expect if a recession were imminent, and yet with an inverted yield curve, combined with historical precedents suggesting a recession would be hard to avoid, advanced economies appeared to be having a Jekyll and Hyde moment. We concluded that the euro area and UK were likely to enter recession in the first half of this year, with the US joining them in the second half.

How have developments since then affected our judgement? Historical precedents, of course, remain. The US yield curve, along with those of other major economies, remains inverted. Indeed, the implied probability that the US is in recession in twelve months’ time has risen from just over 50% in December 2022 to almost 80% today. And yet, there remains a perception that the macro data, particularly in the US, appear stronger than one might expect this far into a tightening cycle. That begs the question: what should one expect to see in the macro data this far into a tightening cycle? We address that question in our first chart, which shows how some of the most closely watched monthly macro data – smoothed and de-trended – have evolved, on average, through US hiking cycles since the start of Paul Volcker’s term in office.

It appears that all four macro series tend to follow a cycle that makes intuitive sense. The most rate-sensitive series are the first to respond: housing starts, which depend on expectations of interest rates far into the future, peak within three months of the first hike, level off, and then start to slow. Durables consumption peaks a month or two later, before it too starts to slow. The cycle in total consumption is more muted, with the peak relative to trend occurring further into the tightening cycle. Finally, payrolls employment is the last to respond, with employment peaking nearly 18 months after the first increase in interest rates.

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So how have those series behaved during the current cycle? This is not easy to assess in real time: the trend level of, for example, GDP can only ever be reasonably estimated several years after the event. Also, the COVID pandemic caused many macro series to exhibit drops and spikes unprecedented in such a short period of time. Fathom’s estimates are reflected in the chart above and the two below. Private housing starts peaked in April 2022, one month after the first increase in interest rates, and fell sharply over the next few months, although the fall has now slowed. Total consumption appears close to its post financial crisis trend, without any clear signs of slowing yet. Payrolls employment fell off a cliff as the pandemic hit, unwinding close to 20 years of jobs growth in a couple of months. Although the recovery has been impressive, employment has seemingly not returned to its post-financial crisis trend — unsurprisingly, given the sharp reduction in participation during the pandemic. But payrolls came up stronger than expected in April 2023, and in all but one of the past 15 months.

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What did this tell us about the impact of the current Fed tightening cycle? One thing seems clear: private housing starts have fallen sharply and even sooner than one might expect. Total consumption would typically be slowing by now, relative to trend, as would durables consumption — but it is hard to say whether either of those things are happening. Payrolls employment would typically still be rising at this stage of the tightening cycle, and at above trend rates – and indeed it is.

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A clearer view of how the degree of economic slack is changing as interest rates rise might come from comparing the number of vacancies with the number of people unemployed. In that regard, the US and UK labour markets appear to remain historically tight, although there are signs of easing. That suggests that upwards pressure on wages is likely to persist.

We conclude that, if anything, the disconnect between the macro data and the financial markets data has intensified in the last three months. In a volatile environment such as now, the odds of a policy mistake appear high. For example, the Fed along with other central banks may err on the side of caution and pause too soon, wary of a rate-related banking crisis. That would see inflation, although no longer in double digits, materially above target for some time. This scenario along with others will be the focus of the Global Outlook, Summer 2023 which Fathom is currently compiling.

The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

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