The first big Wall Street bank to forecast a recession now sees downside risk in its own dovish view

Deutsche Bank, the first major Wall Street bank to call for a US recession during the current era of high inflation, is now going further, seeing downside risks to its own outlook, given the likelihood of price gains. persistently high and continued surprises to the upside.

Describing themselves as “the extreme outlier on the street,” German bank researchers have an official door-to-door call for a “mild” US contraction — placing Deutsche Bank at the bearish end of 75 forecasters surveyed by Bloomberg. . However, they say, an even deeper recession may be needed to control inflation.

Contributing to the likelihood of continued upside surprises in inflation, already at the highest levels in more than four decades, are developments that were already underway before the pandemic, such as climate change and a reversal of globalization, Deutsche Bank researchers said in a published note. on Tuesday. They also said wages are likely to continue to rise considering the tight job market and inflation expectations should rise significantly in the coming year.

On top of all this, there is a dramatically changing psychology of inflation in which those who sell goods and services are willing to pass on cost increases and buyers are willing to accept them, and the notion that even an aggressive policy response from the Federal Reserve will not be enough, according to Deutsche Bank. Its researchers said they wouldn’t be surprised to see the price index for core personal consumption expenditures, the Fed’s preferred measure, at 4% to 5% well into next year before retreating when a recession hits.

“Our internal view is a mild US recession implying a couple of quarters of negative growth and an increase in unemployment of 1 to 1.5 percentage points,” said Peter Hooper, global head of economic research. “A severe recession, which we saw in 2008 and the early 1980s, is a very different animal: something that lasts a year, a year and a half, and has a 5 to 6 percentage point increase in unemployment.”

“The recession we have in mind in this alternative risk scenario to our house call is between the two: something that lasts for several quarters, with a substantial drop in GDP and a rise in unemployment of 3 percentage points, but enough to change the psychology of inflation, Hooper told MarketWatch in a telephone interview on Tuesday.

Generally speaking, professional forecasters and policymakers alike have been shown to be systematically wrong in underestimating the persistence of inflation, particularly as measured by the overall annual rate of the consumer price index, which hit 5% last May and It has been going up ever since. A survey by the National Association for Business Economics, conducted earlier this month, found that nearly half of 84 respondents saw only a 25% or less chance of a US recession in the next 12 months.

Some economists see a recession as likely, though perhaps not until 2024 or beyond. Jefferies LLC noted that all 10 US recessions in the last 70 years were preceded by Federal Reserve rate hikes, but sometimes they took a few years to materialize.

Read: Are recession worries exaggerated? Here’s why a recession seems far away

The chart below shows how far Deutsche Bank’s CPI forecast is, as reflected by the light blue dotted line, from the rest of the pack.

Sources: Bloomberg LP; BLS; german bank

Now, policymakers are assuming they will be able to achieve a “soft landing” in which inflation declines and unemployment remains stable even as they start raising the target federal funds rate by a larger-than-normal 50 basis point increment. . , as of May, from its current level between 0.25% and 0.5%. Activist investor Carl Icahn is among those who have rejected the safe landing assumption.

Washington Watch: Yellen says it’s not impossible for the Fed to engineer a soft landing for the US economy.

The biggest factor behind Deutsche Bank’s view is the likelihood that inflation will remain persistently elevated for longer than expected, according to the note by David Folkerts-Landau, chief economist and head of research; Cooper; and Jim Reid, head of thematic research. They wrote that the only way to minimize the economic, financial, and social damage of prolonged inflation is for the Federal Reserve to “fail to do too much.”

“It’s rare that we get such early warning — we have a substantial inflation problem, and historically the Fed has not been able to deal with this type of inflation problem without a significant downturn in the economy.”

—Peter Hooper, Deutsche Bank

They see the Fed’s main policy rate target above 3.5%, with a shrinking balance sheet contributing the equivalent of another half percentage point in tightening, and a US recession. they see the eurozone slowing to near recession in early 2024, and the European Central Bank also needs to raise rates to deal with an inflation problem “not far behind in the US.”

“What surprises us is that our house call hasn’t turned into a consensus,” Hooper told MarketWatch. He says one reason may be that persistently high inflation is a “fairly recent and sudden development.”

Two other possible reasons, he said, are that “the Fed has yet to recognize potential risks to unemployment, and timing a recession is never easy and often isn’t done until it’s on top of one.” Still, “it’s rare that we get such early warning: We have a substantial inflation problem, and historically the Fed hasn’t been able to deal with this type of inflation problem without a significant downturn in the economy.”

Deutsche Bank became the first bank to predict a recession during the current inflationary era earlier this month, when it revised down its global growth forecasts significantly, in part because of the war in Ukraine.

While lockdowns in parts of China are likely to add to inflationary pressures, Hooper said he expects the country to perform better next year once it weathers the current disruptions from COVID-19, which in turn should ease the likely impact on the US

On Tuesday, US DJIA stocks,

They fell sharply. with the Nasdaq Composite COMP,
It was down more than 3% during the last trading hour. Treasury yields were also broadly lower with the 10-year rate TMUBMUSD10Y,
hovering below 2.76%.

Jeffry Bartash contributed to this report.

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