3 Scenarios That Could Trigger a U.S. Recession: EIU

Analysis June 17, 2022 at 02:29 PM Share & Print

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The U.S. economy was one of the first to recover from the negative effects of the pandemic, with strong residential investment and consumer spending boosting real GDP by 5.7% in 2021. However, upward economic momentum has started to ebb in recent months.

A new white paper from the Economist Intelligence Unit forecasts that U.S. economic growth will slow sharply over this year and next, owing to stubbornly high inflation, rising interest rates and stalling growth elsewhere.

The EIU expects consumer demand to be resilient enough to avoid an outright recession, thanks in part to the tight labor market and strong household balance sheets. But this does not mean that a recession is completely off the cards. The white paper explores three scenarios that could lead to a recession.

See the gallery for three main downside risks to the U.S. economic outlook and potential triggers for a recession.

Risk 1: Second Wave of Inflation

Unforeseen factors prompt another spike in inflation — from an already high level — in late 2022 or early 2023, causing household spending to contract.

Possible triggers: Double-digit increases in the consumer price index for two consecutive months (or more) in the second half of 2022.

EIU expectations: Price pressures will slacken in the second half as energy prices stabilize and supply-chain constraints begin to ease. Annual inflation will slow to around 7.8% this year and to 3.7% in 2023. Household spending will continue to grow year on year, albeit at a sharply reduced pace, thanks to robust household balance sheets and two years of pent-up demand.

Downside scenario: Several risks could precipitate a second wave of inflation that would have a more damaging effect on household spending:

The war in Ukraine intensifies again in the coming months, pushing commodity prices even higher and causing a drop-off in Russian energy supplies that would push energy prices up once again.
The emergence of another Covid variant severe enough to prompt national lockdowns — highly unlikely in the U.S., but China’s zero-Covid policy could affect industrial production and global trade flows, pushing consumer goods prices up.

If inflation were to jump again later in 2022, after rising interest rates and falling real wages have started to bite, an outright contraction in consumer spending could follow, which would push the economy into recession.

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Risk 2: Overly Aggressive Fed

The Federal Reserve overestimates the strength of consumer spending in the summer and raises interest rates more aggressively than expected, causing consumer spending to crater in fall. .

Possible triggers: Combined interest-rate hikes of 150 basis points or more in June and July, coupled with a further decline in consumer confidence measures. .

EIU expectations: The Fed will raise interest rates by a total of 325 basis points, bringing its benchmark federal funds rate to a peak range of 3.25% to 3.5% in March. Following its 75-basis-point hike in June, the Fed will revert back to 50-basis-point hikes in July and September, followed by 25-basis-point hikes thereafter. This pace of tightening will dampen growth in consumer demand and investment, but avoid tipping the economy into recession. .

Downside scenario: There is a risk that the Fed will misinterpret a temporary surge in demand — pent-up pandemic-related demand and return of travel and personal gatherings this summer — as something more permanent and move to rein in consumer spending too aggressively. .

A surge in consumer spending in the summer, coupled with still-high inflation, could push the Fed to tighten more aggressively than the EIU currently expects, say with two or more 75-basis-point hikes in the summer months, which would likely be too much for households to bear.

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Risk 3: Asset Price Collapse

A combination of rising interest rates, high inflation, concerns about the economic fallout from the war in Ukraine and worsening business and consumer sentiment spook U.S. markets and cause asset prices to crash.

Possible triggers: The U.S. bear market deepens. U.S. stock market indexes fall by 40% or more from their recent peak by July as a result of one or more of these factors, without changes in monetary policy to compensate.

EIU expectations: U.S. stock prices will continue to cool in the second half as the Fed begins to withdraw its stimulus and the pace of economic growth starts to slow. However, the Fed will maintain a gradual approach to tightening, helping to prevent a severe collapse in asset prices.

Downside scenario: Although stock markets have officially entered bear market territory (down by at least 20% from a recent peak), asset prices remain well above their pre-pandemic levels. Both the S&P 500 and Nasdaq are up by 10% compared with February 2020.

The cyclically adjusted price-to-earnings ratio developed by Robert Shiller stood at 32 in early June, more than double its low point of 15 reached during the global financial crisis, which suggests that many assets are still overvalued.

This means that asset prices have more room to fall if the economic outlook turns south — for example, if the Fed were to embark on a much more aggressive path of tightening than the market currently expects, or if consumer demand were to contract because of another spike in inflation or another Covid variant.

A collapse in asset prices would exacerbate the drop in consumer spending, as downward movements in household wealth tend to depress more short-term household spending.

(Image: Shutterstock)