Will Inflation Drop Without a Recession? Bank of America Says It’s Possible
We might avoid a recession after all. According to a note from Bank of America strategists in early July, the bank expects to possibly avoid a recession while the Fed fights inflation by raising interest rates.
But is this possible? And what other indicators support this theory that a recession can be avoided?
While most economists are pointing to several indicators that show a recession is inevitable, Bank of America is pointing to one of the most popular indicators to show that a recession might be avoided.
Inflation Will Be Crushed, Not the Economy
According to a note from Bank of America strategists, they are convinced that economic indicators are not pointing to a recession, but rather a steep drop in inflation moving forward.
In 2022, the Federal Reserve hiked interest rates at a historic pace, making it much more expensive for businesses and consumers to borrow money. This slowed the economy slightly, but it has also done its job of slowing inflation.
Inflation peaked in July of 2022 at 9.1% year-over-year, but has recently dropped all the way to a 3% year-over-year increase since June of 2022. This shows that the Fed’s rate hikes are slowing spending and causing prices to stabilize.
But this quick increase in rates has also caused bond yields to invert, which has traditionally pointed to a recession. When shorter-term bond yields are higher than long-term yield, this has successfully predicted the last 10 recessions. And right now, bond yields have been inverted since June of 2022.
Bank of America takes an opposing view, though, stating that the inverted yield curve is actually pointing to a decline in inflation, not economic growth.
“While curve inversion near historical extremes has garnered higher recession probabilities from models, we think curve shape is more a function of expectations for declining inflation than a deterioration in growth,” remarked Bank of America strategists in a note. “A look under the hood suggests that forward real rates do not price elevated recession risk and instead may reflect expectation for softer landing versus consensus.”
Bond Yields Don’t Tell the Whole Story
While short-term bonds yielding higher than long-term bonds can indicate an upcoming recession, it doesn’t tell the whole story. There are quite a few factors feeding into the yields, including sky-high inflation.
But if you look at the forward real yield, the difference expected between bond yields and the expected inflation rate, the drop isn’t as drastic, according to Bank of America. This forward-looking measure suggests that investors don’t expect a massive pull-back in interest rates, but a more gradual taper over time.
“Curve inversion at historically extreme levels does not currently reflect elevated recession risk, but instead is largely related to expectations for cuts alongside inflation converging to target,” say Bank of America strategists in their note.
If a recession were to occur, it is more likely that the Fed would pivot quicker and drop rates quicker to buoy the economy and spur growth to avoid a prolonged recession.
Other Indicators Pointing To a Strong Economy
While there are many predictions of a recession in the U.S., there are several data points showing that the economy is in good shape. Here are a few economic indicators that point to a strong U.S. economy:
- Gross Domestic Product (GDP). An economic recession is defined as two consecutive quarters with a year-over-year decline in Gross Domestic Product (GDP).
- Unemployment. Unemployment remains near all-time lows, with June 2023 data showing a 3.6% unemployment rate. Recessions typically involve a sharp rise in unemployment, which we simply have not seen yet.
- Stock Market. The stock market entered a bear market in 2022 with a drop of over 20%, but it has since recovered significantly, and is within 5%-7% of all-time-high prices. The market usually prices in future risk, and it is not currently indicating an expected recession.
- Consumer confidence. According to the Conference Board Consumer Confidence Index®, consumer confidence rose in June 2023, though still lower than 2021. Nearly half of consumers say jobs are “plentiful” and around 17% expect income to increase going forward.
So, Will There Be a Recession, or No?
Possibly.
With mixed economic indicators, it’s hard to point to a “yes” or “no” answer. Inflation is high and the bond yield curve is inverted, but unemployment is at rock bottom and consumers think we’re going to be fine.
While it’s tough to say what will happen going forward, one thing is for certain: Borrowing is expensive right now compared to a few years ago. And this is the Fed’s playbook, to make loans expensive, cause lower demand and ultimately, lower inflation.
It’s working.
But it’s a tightrope walk that could tip the U.S. economy into a recession. And according to the New York Fed, there’s a 67% chance a recession does happen by June 2024.
Who’s right? We’ll find out soon enough.
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