What next for the US economy?

So far the assessment of appropriate policy from other central banks has been more benign, despite the recent outsize rate adjustments. Communication from European Central Bank officials suggests they plan to reposition policy toward a neutral (not restrictive) stance, which we estimate to be around 1.5 per cent.

A move to recession targeting by the Fed implies a faster pace of near-term hikes to a higher terminal rate.

And while the Bank of Canada and the Fed have said that modestly restrictive policy is warranted, they continue to project inflation to moderate with a year or two of below-trend growth (roughly 2 per cent) instead of shrinking real activity. 

Nevertheless, since inflation is currently as much a global phenomenon as it is a country-specific one, the BoE’s actions raise the question of which central bank will be next to adopt this more 'forceful' approach, and in particular whether the Fed will follow suit.

Any evolution in the Fed’s strategy will have important implications not only for the terminal policy rate, but also for global financial conditions, given the complex interconnections between global capital markets, and the pace of potential cuts thereafter.

Indeed, a move to recession targeting by the Fed implies a faster pace of near-term hikes to a higher terminal rate, which puts further pressure on global financial market risk premiums, but also implies sooner cuts, as inflation also moderates more quickly.

The terminal rate of interest is the peak rate, that is, the highest it will go in this interest rate cycle. 

Recession more likely than not

While the US economy has already experienced two consecutive quarters of negative real GDP, the economy was not likely already in recession as of July. Indeed, other indicators suggest that the economy was still expanding, albeit at a slower pace.

Indeed, the NBER – the formal arbiters of US recession dating – use a more comprehensive definition than the two sequential quarters of GDP contraction rule of thumb discussed by many economic commentators.

In particular, the NBER looks for a “significant decline in economic activity” across various metrics, including real aggregate income and consumption, manufacturing and trade sales and industrial production, and employment based on both the household and establishment surveys. And so far, the evidence is mixed.

More concerning to the Fed, US wage inflation has also broadened from the low-wage, low-skill services sectors to a range of industries, occupations, and skill levels.

Real consumption, current population survey (CPS) employment, real manufacturing and trade sales and IP series have each been choppy, posting small contractions on a month-over-month basis in recent months, while payroll growth has continued at a very robust pace.