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June 23, 2022

Eurozone inflation, US monetary policy and recession forecasts

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Julius Probst
Arnaud Lieugaut
Patrick Malm
Karl-Philip Nilsson
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Euro area inflation

Inflation is ripping through the euro area, having jumped to a record 8.1% in May as energy and food prices stoked by the war in Ukraine roiled the continent’s economy. Our first chart this week shows the extent of the consumer price rises. As you can see, most items are now far above their historical averages. 

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US house prices vs population change

The Covid-19 pandemic has triggered a giant shift in the US property market. First, prices appreciated significantly as remote work turned housing into an even more sought-after commodity. Second, Americans moved away from populous states such as California and New York to seek out more affordable lifestyles in places like Florida and Texas. 

The chart below shows the positive correlation between population change and the house price index. Prices rose most in states where populations have grown fastest – showing the extent to which constrained supply drives the market. 

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US monetary policy

The Federal Reserve hiked its benchmark policy rate by a whopping 75bps this month as it stepped up the fight against inflation. This chart shows how unusual that is. As you can see, the Fed has historically preferred to adjust monetary policy gradually – by raising or cutting rates by 25bps at a time. 

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US coincident index

The extraordinary rate hike makes it harder for the Fed to pull off a soft landing. But just how big is the threat of recession? 

The Federal Reserve Bank of Philadelphia produces a monthly coincident index for each of the 50 states, which combines four state-level indicators to show current economic conditions in a single statistic. At least six states need contract for about six consecutive months to trigger a US recession. As the chart shows, not even one is currently experiencing slowing growth – yet. Keep an eye on this indicator and start worrying when the series falls by six points. 

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New York Fed DSGE model

The Federal Reserve Bank of New York, on the other hand, has shared a forecast that puts the probability of a US recession this year at 80%. 

That outlook was generated through the New York Fed’s DSGE (dynamic stochastic equilibrium) model, which predicts negative GDP growth by Q4 and throughout 2023.

The graph displays the evolution of estimates for both GDP growth and the natural rate of interest. It shows that the latter will rise to almost 1% in the coming years – much higher than the current inflation-adjusted policy rate. This partly explains why the Fed is hiking rates so aggressively now. 

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US GDP forecast via Indicio

DSGE models are based on micro foundations that establish relationships between variables based on macroeconomic theory. They often impose restrictions on certain parameters to make the model work. 

On the other hand, Indicio – a forecasting platform now available to Macrobond users – takes a purely data-driven approach, using dozens of univariate and multivariate models to create an aggregate forecast. 

We wanted to test whether a forecast generated through Indicio would yield the same results as those from the DSGE. The image below shows how Indicio ranks inputted variables by their relevance, or ‘influence coefficient,’ to the main variable – in this case, US GDP. 

Graphical user interface, textDescription automatically generated

The next chart shows the output. The black line indicates the aggregate forecast generated by the model without any restrictions. The green dotted line factors in the Fed’s so-called dot plot, a signal of the central bank’s outlook for interest rates. 

As you can see, both the general and conditional forecasts confirm the New York Fed’s bleak outlook: The former predicts a major slowdown, with growth declining to zero by the end of 2023, while the latter foresees negative growth for the end of 2022 and the first half of 2023. 

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US equities vs interest rates

Our last chart on the US looks at the impact of the Fed’s monetary policy on US stocks. It shows that long-term equity performance typically remained positive through both hiking and cutting cycles – with one exception: The S&P 500 delivered negative returns during the rate hike cycle of the early 2000s when the dot-com bubble burst.

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Australia labour market

The Beveridge Curve depicts the relationship between job vacancies and unemployment and is seen as a measure of the health of the labour market. In a recession, unemployment rises as vacancies falls. When vacancies rise without any change to the unemployment rate, the curve shifts outward – an indication of decreased labour market efficiency. 

The chart below uses the Beveridge Curve to show the impact of the Covid-19 pandemic on Australia’s labour market. Just as in the US, it has shifted outward quite significantly since July 2020 – suggesting a large decrease in labour market efficiency, which in turn will have a negative effect on growth.

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Bank of Japan bond purchases

We wrap up the week with a look at the Bank of Japan’s desperate efforts to defend its yield peg via a bond buying spree. 

As our last chart shows, the BoJ has been snapping up more than four times as much debt as it has historically purchased. It now holds close to 50% of all Japanese government bonds. 

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