As discussions about the possibility of the economy avoiding a recession gain momentum, a Deutsche Bank economist warns that danger still looms. Jim Reid, the head of global economics at the bank, emphasizes that optimistic sentiments before an economic downturn are not uncommon. In a client note, he states, “Remember that even as soft landing talk has gathered pace, this is not unusual before recessions.” While the labor market in the United States and parts of Europe continues to remain strong, Reid urges caution and highlights various indicators that suggest a potential storm on the horizon.
One of the primary factors that contribute to the soft landing narrative is a persistently robust labor market. In December, the U.S. Labor Department reported the addition of 216,000 jobs, maintaining an unemployment rate of 3.7%. This positive trend aligns with a strong labor picture throughout Europe. Reid acknowledges the merits of this argument, including low unemployment rates, inflation gradually aligning with the Federal Reserve’s target, an resilient consumer, and no signs of a recession in personal consumption.
However, despite the optimistic outlook, Reid also foresees potential risks and challenges on the horizon. One notable concern is the time lag associated with interest rate hikes. The last rate hike occurred in late July, which means it is still “relatively early” in a cycle that typically takes 19 to 28 months to fully play out. Reid warns that a recession before the start of the fourth quarter in 2023 would be historically unusual and highlights the increased risks present now compared to previous years.
Reid points to historical patterns involving the yield curve as an additional cause for concern. Inversions in the yield curve have often accurately predicted recessions. Moreover, credit conditions are tightening, which can have adverse effects on consumer spending. Areas such as commercial real estate are also likely to experience negative consequences. These factors, combined with the potential fallout of escalating trade tensions, further highlight the uncertainties that lie ahead.
Despite these warning signs, the economy has proven resilient and continues to defy skeptics. The Atlanta Fed’s GDPNow tracker indicates that fourth-quarter GDP is expected to post a 2.5% annualized gain. Additionally, the New York Fed’s recession probability gauge, which measures the spread between 3-month and 10-year Treasury notes, has dipped to 63%, albeit still relatively high. Interestingly, even Deutsche Bank’s U.S. economics team suggests that a soft landing may be possible, emphasizing the potential mitigating effects of expected interest rate cuts by the Federal Reserve. Their outlook, projecting a greater number of rate cuts than initially anticipated, demonstrates a more aggressive stance than what is currently priced into the market.
Despite the alignment of optimistic data and trends that seem to point towards a soft landing, Reid reminds us not to grow complacent. He emphasizes that at this stage of the economic cycle, data often presents a positive outlook, making it crucial to remain vigilant and consider the broader historical context. While the current indicators may provide comfort, it is important to recognize that these conditions have prevailed before previous downturns.
The possibility of an economic recession remains a topic of both optimism and caution. The strength of the labor market and positive trends in consumer spending paint a picture of stability and potential soft landing. However, the significance of time lags associated with interest rate hikes, historical patterns of yield curve inversions, and tightening credit conditions cannot be ignored. As the economy continues its journey, it is essential to maintain a critical eye and monitor the evolving indicators that may foretell the arrival of a recession. Only through careful analysis and consideration of historical patterns can we navigate the capricious nature of the economy with prudence and preparedness.
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