Morgan Stanley warns that accelerating growth and inflation places the U.S. economy at a 15% risk of recession in 2019 and a 30% risk in 2020.
The bank’s research team published a note Monday saying the Federal Reserve now faces its “greatest challenge”: when to stop raising its benchmark interest rate. Policymakers are trying to lift the federal funds rate target, currently at a range of 2% to 2.25%, to match the economy’s longer-run neutral real rate. A number of Fed speakers will be closely watched this week ahead of a December 18-19 meeting where the Federal Open Market Committee is expected to hike rates by another 25 basis points.
‘The third phase’
As the Fed continues to search for neutral, market commentators are starting to look to the next chapter of monetary policy, which New York Fed President John Williams describes as the “third phase.” Post-accommodation, the Fed will likely be focused on maintaining the neutral rate where GDP growth is moving in line with potential output growth, the unemployment rate levels off, and inflation stabilizes around the 2% goal.
“Unfortunately, in the real world, things never seem to play out that way,” Morgan Stanley said.
Here’s how Morgan Stanley sees it playing out:
In 2019, a one-off tax refund season jolts spending and savings but the “hangover” from fiscal stimulus fades as Fed rate hikes further tighten financial conditions. Compared to GDP growth of 3.1% in the fourth quarter of 2018, economic growth slows to 1.7% in the fourth quarter of 2019 as part of a “growth correction.”
But by the end of 2019, the healthy wage growth and strong consumer spending push the unemployment rate down from 3.7% in 2018 to 3.4% in 2019 as wage growth accelerates from 3.1% in 2018 to 3.5% by year-end 2019. Inflation also jumps, as core PCE rises to 2.3% by the end of 2019, up from 2.0% as of the latest reading in September.
As a result, the Fed eases financial conditions through four rate hikes in order to curb growth in 2020.
“The Fed is caught playing catch-up to an overheating economy,” Morgan Stanley writes.
The final prediction: The economy enters a stall in the business cycle where there is a 30% chance of a recession.
The trigger? Not household credit or risk in the financial system, but non-financial corporate leverage, which Morgan Stanley describes as the “biggest threat to the economy currently.”
With higher interest rates and deteriorating credit quality, Morgan Stanley and a number of other economists — such as former Fed Chair Janet Yellen — worry that leveraged lending could present systemic risk to the economy if an event forces widespread losses.
Brian Cheung is a reporter covering the banking industry and the intersection of finance and policy for Yahoo Finance. You can follow him on Twitter @bcheungz.