Economic and Market Commentary

Inflation, Recession and the Road Ahead

PIMCO Economist Tiffany Wilding shares her economic outlook for the next 12 months, and some potential positive outcomes of today’s challenges over the long-term.


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Text on screen: PIMCO

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Text on screen: Ken Chambers, Product Strategist

Chambers: Can you maybe set the stage for that cyclical conversation as well as highlight a couple of relevant factors that are going to impact both markets and economies over the next 12 months?

Text on screen: Tiffany Wilding, Economist

Wilding: So, remembering back in March, the war in Ukraine had just started and we characterized it as an anti-Goldilocks economic shock, whereby accelerating inflation would likely be accompanied by slower and maybe even negative economic growth.

Text on screen: TITLE – Three key economic impacts: BULLETS – Effects of the war in Ukraine, Entrenched inflation, More pronounced central bank reactions     

I would argue that the developments have kind of evolved along these lines and I think three keyways. The first is just the economic effects of the war in Ukraine, resulting sanctions have been much more pronounced than what we were expecting. Inflation is now looking much more entrenched. That's true not only in the US, but I think across the large developed markets. And then third, the central bank reaction to that has also just been much more pronounced. So, what does that mean for the economic outlook?

Well, we've characterized the outlook as basically mounting macro misery for central banks because it's going to, these macro shocks are going to result in recessions across large developed markets, we think. Inflation, nevertheless, is probably going to end up being stickier than many people thought. And of course, central banks will have to engineer their real policy rates above their neutral levels in order to bring inflation back down to target.

Chambers: Yep. Recession risks, and really the timing of that recession. We note in the piece that unemployment is poised to rise and that a recession is more likely than not. Can you talk about our views or expand upon that in terms of both timing, depth, shape, and of the recession as well as maybe a recovery?

Wilding: Yeah, sure. So obviously we think recession and rising unemployment across large developed market is more likely than not.

FULL PAGE GRAPHIC: TITLE – Inflation: Appears stickier across developed market economies. The line chart shows Sticky Core Price Inflation rates across the U.S. (as represented by the dark blue line), Euro area (red line) and the U.K. (light blue line). Sticky price inflation rates have risen steadily in all three regions. In the U.S., the rate rose from approximately 2% in July 2020 to 6.5% in July 2022. In the Euro area, the rate rose from approximately less than 1% in July 2020 to approximately 4.6% in July 2022. In the U.K., the rate climbed from approximately 1.3% in July 2020 to 5.5% in July 2022.

I think that's especially the case in Europe and the UK. The energy supply crisis in Europe has resulted in Europeans facing record high gas prices. That will, of course, in turn limit discretionary income, render some factory activity in Europe on economical and just generally increase the cost across the supply chains.

Turning to the United States, we are relatively energy independent as a result of the shale revolution, nevertheless, these global trade disruptions will have a stagflationary impact on the United States. And in addition to that, we're dealing with the fastest pace of financial conditions tightening that we've seen since the Lehman bankruptcy in 2008. So that's just going to weigh on the United States economy more dramatically.

FULL PAGE GRAPHIC: TITLE – Recession: More likely than not, unemployment poised to rise. U.S.: Tightening financial conditions tend to precede increases in unemployment. The chart has two lines. The blue line shows the federal funds rate, which has moved from zero in 2020/2021 to above 2% in 2022. The green line shows the U.S. unemployment rate, which rose above 14% in 2020 at the height of the COVID-19 pandemic, and has since dropped to less than 4%, but has slightly increased as of August 2022.

We think ultimately that puts pressure on corporate profits that will ultimately limit investment. Housing in the United States obviously is a key sector that is interest rate sensitive. We're already seeing a contraction in real economic activity and housing. And ultimately all this we think probably flows through to rising unemployment throughout next year.

So, as a result of this sticky inflation and the central bank response, I think there's still reasons to believe this could be a relatively shallow recession. Because we started off with initial conditions of pretty strong balance sheets across the household and corporate sector. However, it could be more prolonged.

FULL PAGE GRAPHIC: TITLE – Financial Conditions: Less accommodative conditions are likely to continue. The line chart shows the PIMCO Financial Conditions Index (FCI), which is a proprietary index that summarizes information about the future state of the economy based on a wide range of financial variables, such as the fed funds rate, bond yields, credit spreads, equity markets, oil prices, and the broad trade weighted US dollar, all of which impact the economy. An increase in the FCI implies a tightening of financial conditions (less accommodative), while a decrease implies a loosening of financial conditions (more accommodative). As of September 2022, the index has moved higher to a level that is close the past tightening period in 2008.

And the reason is because that counter cyclical policy response that you usually get as a result of weakness and growth, central bank, which is dropping rates to zero, or the fiscal policy authorities, which are doing fiscal stimulus, you're just not going to see that on an elevated scale. So even when the US or other developed markets do come out of this recession, we think they're probably in for a period of kind of still subpar and sluggish growth.

But I do think over the longer term though, the consequences of bringing inflation down will ultimately be positive because it will allow not only the US economy, but the rest of the world to really focus on maybe supply-side types of investments and innovation that results in, for example, a better transition to brown to green, more resilient supply chains over the longer term and hopefully higher productivity growth.

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