Economic Conditions Resilient, So Far

Continued high prices through most of next year and the Fed's decision to aggressively raise rates--and therefore accept the collateral damage to the U.S. economy--will lead households to pull back on spending and businesses to cut their costs and workforce. Fortunately, with several emergency facilities now in place, allowing banks to fail is apparently not on the Fed's agenda. If regulators are successful, it suggests the economic fallout from banking stress could be manageable.

But it doesn't mean the U.S. economy is completely safe. Since our September forecast, we expected the U.S. to fall into a shallow recession in 2023. We now expect U.S. GDP to decline by 0.3 percentage points from its peak in first-quarter 2023 to its third-quarter trough. If correct, this will beat the 2001 recession as the softest recession in recent history, since 1960. Although safeguards from the Fed and other regulators have stabilized conditions, banking concerns increase risks of a worse outcome.

Chart 1

Our forecasts were developed during a period of high market volatility and significant policy changes, and therefore have wider than normal confidence bands. Forecasting began before the failure of Silicon Valley Bank.

Table 1

Recent indicators suggest a rather tame outlook. Rising prices and interest rates are cutting into private-sector purchasing power, but healthy private-sector balance sheets provide a cushion. Cumulative household savings have declined from their peak in 2021, when aggregate savings reached around $2.5 trillion more than 2019 savings, but they remain $1 trillion more than 2019 levels (see chart 2).

In addition, the jobs market remains tight, with healthy wages providing another cushion to offset higher prices and interest rates, although it is a challenge for the Fed. U.S. nonfarm payrolls increased by a better-than-expected 311,000 in February, after jobs gains topped 500,000 the prior month. On healthy job gains, average hourly earnings rose 0.2% and are up a hefty 4.6% year over year, up from 4.4% year over year in January and nearly twice their historical average of 2.5%, increasing wage spiral concerns. Job openings have come down from record highs but remain strong (see chart 3). This highlights continued challenges from the jobs market as the Fed tries to tame inflation.

Chart 2

Chart 3

March Madness In The Markets

Markets headed into the weekend on March 10 with sobering news: The 16th largest bank in the U.S. collapsed as the combination of huge deposit withdrawals (on the realization of large investment losses) and interest rate risk was the proximate cause (see "The Macro Fallout From The Silicon Valley Bank Collapse Appears Limited For Now," March 16, 2023). These losses stemmed from the decline in the value of fixed interest rate assets purchased when rates were relatively low. As market rates rose sharply over the past year because of the Fed's efforts to rein in inflation, the value of these assets declined and weren't realized initially since the bonds were held in the bank's held-to-maturity (HTM) portfolio.

Shaken by the suddenness of the first bank failure since 2008, markets fled to safe-haven assets. From March 6 to March 13, U.S. 10-year bond yields plunged by 49 bps to 3.49%, while U.S. equities fell by 4.76%. 10-year yields fell to 3.41% by March 23, while equity markets are still 2.6% below March 6 levels. As of March 17, our quantitative assessment of recession risk, using the 10-year/three-month spread, suggests a 63% probability of a recession in the next 12 months, up from 52% in our January U.S. Business Cycle Barometer publication (see "U.S. Business Cycle Barometer: Constrained By Tight Monetary Policy And Global Slowdown").

Markets on March 15 priced in no rate hikes at the Fed's March meeting and significant cuts later in 2023, with most expecting the fed funds rate to drop to 3.25%-3.5% by the December 2023 Federal Open Market Committee (FOMC) meeting (see charts 4 and 5).

Chart 4

Chart 5

U.S. and global regulators moved quickly to control damage from market turbulence generated by SVB's collapse and fears it could spread to similar banks. Regulators guaranteed all deposits of SVB and Signature Bank and launched the Bank Term Funding Program to help avoid the fire sale of assets carrying interest rate risk. So far, these extraordinary measures seem to have calmed the markets and limited contagion to other banks.

FOMC Whiplash

The Fed's job is now twofold: tame inflation and stabilize financial markets. Central banks have numerous instruments to achieve their policy objectives, hence the rapid response post-SVB collapse.

Specifically, central banks can use their balance sheets through various facilities to provide financing and liquidity to help banks shore up their balance sheets (extended time frames if needed). Independently, banks can continue to adjust their short-term policy rates to influence financial conditions and guide inflation back to target. Although inflation remains hot, the Fed did an about-face at its March FOMC meeting.

The FOMC raised rates another 25 bps on March 22 as we expected. While many Fed watchers called for a pause, we saw that as very unlikely given credibility factors. We continue to expect another 25-basis-point hike at the May meeting. But while the Fed remains vigilant on reducing inflation, it kept its "high for longer" interest rates message. The Fed has indicated that tighter credit conditions stemming from the bank failures will push inflation lower with aggressive monetary policy.

The FOMC's new projections and Fed Chair Jerome Powell's press conference indicated this change of heart among policymakers was the real story.

The FOMC indicated that it is monitoring incoming information "closely" and swapped out "ongoing increases in the target rate will be appropriate" with a much softer "some additional policy firming may be appropriate." No changes to the balance sheet program were made or even "discussed yet." Although, Fed Chair Powell made clear that rate cuts are not in the FOMC "base case," in defiance with what the market forward curve projected. With a mix of dovish and hawkish elements in the statement, it highlights considerable uncertainty on how tighter credit conditions will affect the outlook for the economy and monetary policy. While we expect continued strength in the jobs market and sticky inflation will drive another 25-basis-point hike at the May meeting, banking conditions will be the headline throughout.

While the Fed has turned its attention to the greater of two evils, inflation remains a problem, with service prices--excluding housing--particularly sticky (see chart 6). With the personal consumption expenditures (PCE) deflator over 2.5x the Fed's 2.0% target and core PCE inflation, the Fed's preferred indicator, almost 2.5x its target, the Fed will keep an eye on prices to measure whether tighter credit conditions do tame inflation. Fortunately, there are signs that inflation expectations have come off recent highs, though not enough for the Fed to claim a win (see chart 7).

Chart 6

Chart 7

Uncertainty Remains High

While S&P Global Ratings Economics sees a very shallow U.S. recession in its baseline forecast, in such an uncertain environment, the U.S. economic outlook could have either faster or slower growth than the baseline.

Most pressing from a U.S. perspective is the timing and pace of U.S. monetary policy, as the Fed tackles inflation, which remained high on continued supply-chain disruptions. Distress in financial markets, highlighted by the SVB collapse, complicates chances that the U.S. economy will have a soft landing. It also forces the Fed to hold off on tightening, allowing inflation to get further ahead.

Table 2