What If Elon And Goldman Sachs Are Wrong?

What If Elon And Goldman Sachs Are Wrong?
Carl Hazeley

over 1 year ago3 mins

  • A central bank that promises to hike interest rates until inflation falls, as the Fed is doing, usually runs the risk of triggering a recession.

  • But high consumer and business cash balances, some already slowing wage growth, and the scope for falling profits all suggest that this time may be different.

  • Because of those three factors, the Federal Reserve may have a better of both avoiding a recession and bringing inflation down quickly.

A central bank that promises to hike interest rates until inflation falls, as the Fed is doing, usually runs the risk of triggering a recession.

But high consumer and business cash balances, some already slowing wage growth, and the scope for falling profits all suggest that this time may be different.

Because of those three factors, the Federal Reserve may have a better of both avoiding a recession and bringing inflation down quickly.

Mentioned in story

Elon Musk said this week that he thinks a US recession is probably on the cards in the near term, while investment bank Goldman Sachs just updated its forecast to show that a recession is now more likely to happen in the next two years. But there are three reasons they might both be wrong…

1. Profit margins are at extraordinarily high levels.

The Federal Reserve chair said last week that the central bank would continue raising US interest rates until there’s a noticeable drop-off in inflation compared to the previous month. As a general rule, if a central bank is still hiking rates after inflation has peaked, it’s gone too far and may trigger a recession.

But there’s one reason why the odds could favor the Fed this time: company profits are likely to fall from their very high levels because of rising supply, not falling demand. See, demand has outstripped supply for everything from microchips to energy as the pandemic receded, and as supply disruptions in places like China, Russia, and Ukraine pushed up prices of the products that are available. The expectation is that supply improves globally in the next few months, and that will lead companies to cut prices in order to be competitive, helping bring inflation down. And, sure, it’ll reduce their profit margins, but companies would probably rather have more competition with stable demand than have falling demand, which is what typically accompanies rising interest rates.

Source: Pantheon Macroeconomics.
Source: Pantheon Macroeconomics.
Source: Pantheon Macroeconomics.
Source: Pantheon Macroeconomics.

2. There’s a lot of cash in the system.

Households have more money in cash – about $3 trillion more (give or take) – than they had at the start of the pandemic, so people are in a better position to handle higher food and fuel prices.

Of course, that $3 trillion isn’t distributed evenly (or fairly, for that matter). And the poorest are suffering the most: they were spending almost 30% of their income on food and energy before prices jumped – so their cash balances have fallen. But consumer spending overall isn’t usually driven by those with the lowest incomes, and better-off people are so far continuing to spend. That’ll run down their savings, sure, but it may also help the US economy avoid a recession.

Source: Pantheon Macroeconomics.
Source: Pantheon Macroeconomics.

Companies, meanwhile, have about $300 billion worth of extra cash – and, for now, debt costs are still locked in at low rates. That should encourage companies to keep investing in equipment and machinery (a.k.a. capex) – and that spending could help avoid a recession.

3. Wage growth is already slowing.

When inflation’s ablaze as it has been and finding workers is difficult, companies are often quick to hike pay – which itself fuels further inflation. When a central bank hikes interest rates in response to all that inflation, the effect eventually catches up with companies, which, faced with higher costs (including more expensive workers), will see a drop in profits and may cut staff. And those job cuts tend to be quickly followed by a slowdown in the rest of the economy.

But wage growth has been slowing down recently – from an annualized rate of 6.5% in the third quarter of last year to around 4% in the second quarter of this year, according to research firm Pantheon Macroeconomics. And that slowdown might be here to stay, especially given the recent rise in the number of people who are actively looking for jobs.

Typically wage growth rises in the later stages of the cycle, forcing central banks to worry about “embedded,” or persistent, inflation. But with wage growth slowing already, that seems unlikely this time around.

In fact, the most wage-sensitive elements of core inflation are already slowing sharply. That suggests that the monthly inflation downturn that the Fed wants to see could happen sooner than most economists expect – and that by September, the US central bank could be in a position to begin making smaller rate increases, if any.

In that scenario, a recession would be very unlikely indeed. And if one did come to pass, it’d be brief and mild.

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