By Tiffany Wilding, PIMCO’s North American Economist
Last week, the Bank of England (BoE) was the first major central bank to admit that it is forecasting a recession to restore price stability. As was widely expected, the BoE delivered a 50 basis point rate hike – the largest adjustment for a single meeting since the 1990s. In an unexpected move, BoE officials also revised lower their projections for real GDP growth and now expect a deeper recession lasting for seven quarters starting in 4Q22, with GDP falling by −2.2% (peak-to-trough).
The BoE’s recessionary outlook was not so surprising in the context of the war in Ukraine and resulting European energy supply shocks that have raised global energy prices and will drag on economic activity in the U.K., which is a net energy importer. However, what was more surprising was the depth of the BoE’s recessionary outlook and their resolve to use all of its available tools to tighten policy despite a gloomy real growth outlook. Notably, BoE officials didn’t push back on the market pricing of a peak policy rate at 3.0% – 125 basis points higher than the current 1.75% level, which they already view as restrictive, according to our U.K. economist, Peder Beck-Friis (the policy rate is a direct input into their recessionary growth and inflation forecasts). Instead, they emphasized their price level mandate and committed to continue to act “forcefully” to bring down inflation, which we interpreted to imply another 50-bp rate hike is likely in September. Further, the BoE also committed to continue quantitative tightening by starting active gilt sales shortly after the September meeting. At a pace of sales around £10 billion per quarter, the sales would shrink their gilt holdings by roughly £80 billion per quarter when you include redemptions that will not be reinvested.
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 (ECB) officials suggests they plan to reposition policy toward a neutral (not restrictive) stance, which we estimate to be around 1.5%. And while the Bank of Canada and the Federal Reserve 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%) 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.
Evolution in the Fed’s outlook will depend crucially on the persistence of inflation. While there is still a plausible path toward a soft landing in the U.S. – i.e., inflation moderates without a recession – the credibility of that outcome is declining quickly. As we’ve written in recent Signposts, the outlook for inflation has become increasingly uncertain. The underlying trend in U.S. inflation appears to have adjusted higher in recent months, although easing food and energy prices will moderate headline inflation starting with the July CPI print (released August 10). Core measures of inflation (e.g., Cleveland Fed trimmed mean, the New York Fed underlying inflation gauge, Atlanta Fed stick price measure), which are better predictors of future inflation, have all accelerated, with the depth and breadth of inflationary pressures across items in the consumer price basket accelerating. More concerning, the dynamics of wage inflation aren’t much different. Wage inflation has also broadened from the low-wage, low-skill services sectors to a range of industries, occupations, and skill levels. The Atlanta Fed wage tracker, which doesn’t suffer from distortions due to compositional shifts, has increased rapidly – behavior that resembles a non-linear Phillips curve, and/or accelerating inflation expectations. Furthermore, this has happened despite a productivity recession, implying unit labor costs have substantially increased – something corporations will want to offset by rising prices to maintain margins. Unit labor cost inflation appears to be growing at 7% on an annual average basis, which has historically implied core CPI inflation of closer to 4%.
What’s more, the likelihood that the U.S. is currently in recession, or will be in recession by the 3Q, fell further last week, with the release of the strong July employment report and ISM services PMI. Although various labor market indicators (claims, NFIB job openings survey, Conference Board current labor market conditions survey, etc.) suggest that the labor market, similar to real GDP growth, is losing momentum, that was not evident in the July establishment survey. Although labor markets, which lag broader growth trends, are likely to slow, the strong momentum thus far, coupled with strong wage numbers, put the Fed squarely on track for another 75 basis point rate increase at the September meeting, and to once again revise up their expectations for the fed funds rate at year-end. This revision would position monetary policy to be restrictive, well below the rate required for this type of stance in 1970s and 1980s, because despite elevated cyclical inflation, the real neutral interest rate is still likely very low.
Whether the Fed ever admits to targeting a recession is another question. As a result of its dual mandate toward maximum employment and price stability, it will be more difficult for the Fed. Perhaps the closest the Fed will ever come is to say that the only way to achieve maximum employment over time is to restore price stability, exactly what Powell has said on numerous occasions. Furthermore, when tightening policy, the benefits of clear communication and concrete forward guidance, which became a hallmark of post-GFC central banks, become less clear.
What’s the Bottom Line? Whether Fed officials admit it or not, we think they are quietly shifting toward the idea that a period of below-trend growth won’t nearly be enough to fully moderate inflation pressures. Instead, similar to the BoE’s outlook, a more forceful approach in the context of a still low real neutral rate may be warranted. As a result, although the near-term prospects for recession have diminished, the recessionary outlook 12 to 18 months out is arguably more likely. In other words, the pre-pandemic era of the kinder, gentler central banker is over.