Assessing current threats to the US economy

Before Russia’s February 24 invasion of Ukraine, the outlook for the U.S. economy was bleak but promising. Pandemic pressures appeared to be peaking, inflation was expected to return to normal, and the Fed had a credible chance of engineering a “soft landing.”

But a massive humanitarian atrocity in Europe has sparked an unexpected global financial and economic conflict whose consequences will ricochet. Although new risks have emerged, and uncertainty is high, the main impact of the crisis on the US economy at this time is to exacerbate existing pressures and risks. The path of inflation, and the policies to control it, are the biggest risks to the cycle. Although this risk has increased, it should not result in a recession.

How the triggering bet is played.

As we wrote here last year, policymakers made a big bet at the start of 2021 that extraordinary stimulus would turn a strong recovery into an even stronger expansion. The payoff would be a “narrow” economy—one that provided broad-based real wage gains that firms paid for not by raising prices but with higher productivity growth. A win for workers, firms and politicians.

That preferred scenario has not materialized. The tight economy arrived with signs of strong nominal wage growth and productivity growth. But inflation has risen sharply, as firms have discovered pricing power and used it extensively to protect their profit margins. In February, year-over-year price growth was 7.9 percent, a 40-year high.

But it would be wrong to blame the stimulus alone. Inflation was also driven by supply chain disruptions – exacerbated by waves of the virus that disrupted production and slowed inventory recovery – and a labor market scrambling to hire workers. , while labor supply slowly returned to normal.

It seems the pressure is on.

Nevertheless, there was clear evidence that the US economy had undergone economic stress. In product markets, demand was normalizing, even slowing in many hot areas, such as consumer durables, while inventories were rising. In the labor market, the frantic pace of hiring had eased, while the labor supply was finally returning to normal.

February employment reports, Released on March 4., highlighted all this. Firms were largely able to hire larger numbers of workers (+654K private payrolls), facilitated by continued strong increases in labor participation. Meanwhile, wage growth, though still up year-on-year, was flat month-on-month. All this would be a bullish sign that the economy is strong and the pressure is easing.

How war increases the risk of recession.

The Russia conflict has rendered these markers of economic strength almost irrelevant as high-profile risks take center stage. The prospect of continued conflict and a changed geographical reality has yet to sink in. But it’s not too early to wonder how that might play out. Is a recession in the cards now?

The impact of an economic shock is delivered through one – or several – of three mechanisms. transmission channels. Let’s see where the risks are greatest and why.

Financial recession. Be the harmful type. They emerge when a shock paralyzes banks, either through liquidity or capital concerns that force them to deleverage. In their context, they leave behind lasting asset value damage, poor investment plans, and slow recovery. That was the story in 2008 – but it was successfully averted in 2020.

Before the war, the American banking system was in strong shape and exhibited very limited stress. US banks’ capital positions are strong, profitability is at its best in years, and liquidity is extremely flush. Exposure to Russian assets is limited, and live data on credit spreads is reassuring.

So far, there are unknowns. Banking is a highly interconnected ecosystem, which can hide vulnerabilities. A new threat that emerges is a vulnerable cyber-attack on Western financial infrastructure, the obvious reason why the financial sector is never a source of serious surprises.

A recession in the real economy. are usually mild and are affected by sudden demand or supply shocks that can tip an already weak economy into recession. Has the Ukrainian conflict generated enough heat to cause such a big shock? Some highlights on the negative side of the ledger are:

  • Energy prices (direct effects): In 2021, oil prices in the US (WTI) fall from $50 per barrel to more than $75 per barrel. If prices had stayed where they were, the effect on inflation (and real income) would have been smaller, since inflation measures Change In prices, not price The surface. However, as a result of the Ukraine invasion, prices have reached $130 per barrel, a similar increase to last year’s prices and again affecting real incomes.
  • Energy prices (impact on reliability): Energy prices also have a clear—inverse—correlation with consumer confidence. Consider that confidence in the last expansion did not recover strongly until oil prices collapsed in 2014.
  • Effects of Wealth: Falling asset prices mean households feel less wealthy and cause them to hold back on spending and save more.
  • Constraints in supply chain: Russia’s attack is another blow to globally integrated supply chains that have repeatedly lost economic output over the past two years.

Despite the magnitude of the headwinds, it is not yet clear that they outweigh the tailwinds underpinning the US economic cycle:

  • Growth, although slowing, is keeping pace and running above trend growth in 2022, providing some insulation from shocks.
  • The domestic sector remains healthy, as balance sheets across income groups are still very strong, including high cash balances.
  • Labor markets are very tight, with record job openings, strong employment, and strong wage growth providing a strong domestic tailwind for continued consumption.
  • Firms remain highly profitable and are interested in investment, as they want flexibility and new capacity.
  • Direct U.S. trade links with Russia and Ukraine are modest overall, and potential disruptions will occur as the U.S. continues to re-emerge from the Covid shutdown.

These tailwinds and headwinds are not absolute, nor is it possible to reliably plot them against each other. But the background to the US cycle is what suggests the expansion could continue.

A policy malfunction remains a central recession risk.

This means that the most plausible source of risk is the so-called policy error recession. Even before the war, policy error was the main threat to expansion: interest rates could rise too low or too slowly and inflation could spiral out of control. A growth rate that is too high or too fast and an unnecessary recession.

War has made the Fed’s high-wire act even more dangerous. To get the balance of headwinds and tailwinds right, policymakers must interpret all the drivers we’ve discussed so far—energy, labor markets, product demand, supply chains, etc.—without complete visibility or of timely data. The impact of energy prices, for example, was quite difficult to predict before the war. Now it has become very difficult, and therefore the risk of policy failure is also very high.

Before the attack, markets saw the Fed raising interest rates seven times through early 2023 to bring inflation under control. Many observers feared that this would be too much for the cycle to survive. Today, the market is still seeing about seven gains – essentially unchanged despite a massive increase in uncertainty. The key question is not whether the war derails the expansion, but whether the Fed can negotiate a soft landing with this degree of tightening.

What Executives Can Do

As the shock of an attack reverberates through the economy and cyclical risk increases, executives will try to minimize the impact on their businesses. Here are some dos and don’ts.

  • Do not rely on forecasts as extreme uncertainty prevails. Vulnerable at the best of times, they remain out of reach.
  • Build capabilities to analyze and model shock and stress test transitions using scenario planning.
  • Don’t assume that shocks cause structural change – they can, but in the fog of the moment the bar of inflection is often deceptively low.
  • Don’t assume that pricing power is intact. As growth moderates and inventories build, firms may well return to defending market share.
  • Think of productivity growth as a sustainable source of competitive advantage.

Russia’s invasion of Ukraine comes just as the pressure on the US economy is at its peak, and the prospects for a soft landing are good. The coming days, weeks and months will reveal more about how this affects the US economic cycle. A recession is not a foregone conclusion, and companies must remain flexible, reassessing their approach and strategies as events unfold.

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