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Worsening financial conditions likely to tip US into recession

The sharp worsening in financial conditions — which accelerated last week with a steep decline in equities, a jump in term interest rates, a further rise in the dollar, and a widening mortgage rate spread — points to a further weakening in spending that will cause the US economy to slide into recession in coming quarters.

We expect the recession to be mild by historical standards. The unemployment rate is likely to rise by several percentage points. This weakening in product and labor markets will ease inflationary pressures. We will formally update our US forecast over the next several days.

Even more impactful than the Federal Reserve’s Sept. 21 decision to raise the federal funds rate were significant revisions to forecasts of inflation and interest rates submitted by Fed policymakers as incoming data show that inflation continues to run far above the Fed’s 2% objective.

Policymakers anticipate raising interest rates considerably higher than suggested by forecasts as recently as June. Median forecasts from members of the Federal Open Market Committee (FOMC) show the upper end of the target range rising to 4½% in December and to 4¾% in 2023.

Uncertainty in the outlook is high, and the actual path of the federal funds rate could run either above or below median FOMC forecasts. Clearly, the direction of travel is toward additional Fed tightening that will weaken growth with the intent of softening demand in product and labor markets and pushing inflation down to 2% over time.

On Sept. 21, Powell repeated that slaying inflation will cause pain. The change in our forecast brings home that point! The longer inflation remains elevated, the further the FOMC will be forced to raise interest rates to weaken demand to reduce inflationary pressures.

If the economy slips into an outright recession as we are now expecting, inflation may ease more quickly than the FOMC expected when it met on Sept. 21. That could impact the path of the policy interest rate going forward.

Increases in global interest rates as other major central banks tighten to reduce inflation reinforce upward pressure on Treasury yields. The dollar appreciated approximately 2% against the euro last week. The dollar rose against the yen prior to intervention by the Bank of Japan to support its currency. Since last November, the dollar has appreciated against both currencies by approximately 20%.

Our forecast of third-quarter GDP growth remains unchanged from one week ago at 0.4%.

This week’s US economic releases:
• Manufacturers’ new orders for durable goods (Sept. 27): A decline would be the second consecutive dip following increases averaging 0.9% per month over the prior twelve months. The slowing profile reflects a recent flattening of producer prices within durable goods manufacturing industries.
• New single-family home sales (Sept. 27): We estimate 506 thousand units, compared with 511 thousand units in July. This would continue the weakening trend in sales of the last several months. The housing market has been pummeled by rising mortgage rates, elevated prices, and sinking affordability.
• Conference Board Consumer Confidence Index (Sept. 27): We expect an increase of 0.9 point to 104.1, as retail gasoline prices, a key driver of inflation expectations, continued to fall in September.
• Nominal goods deficit (Sept. 28): We expect a $6.9 billion widening to $97.1 billion.
• Nominal personal income (Sept. 29): We expect a rise of 0.2%.
Source: IHS Markit by Akshat Goel, Ben Herzon, Chris Varvares, Ken Matheny, https://ihsmarkit.com/research-analysis/us-

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