Vanguard’s economic and market outlook at midyear 2022

Joe Davis: Inflation is at generational highs, and many are concerned about the threat of recession. So, what’s Vanguard's view?

Our own economic projections now indicate a greater than 50% probability of a recession occurring over the next 12 to 18 months, both in the United States and other developed markets, in particular Europe.

Why the increased odds of recession? Well, now we have two forces pushing on inflation. The well-documented supply constraints of food and energy and other products leading to higher costs of living for many consumers and businesses. And the second force, which we have long documented—the tight labor market pushing up wage pressures, which also contribute to higher inflation for a number of products and services.

Now, greater than 50% odds are not 100%, and recession is not a foregone conclusion. So, what would it take for the U.S. economy and other markets to avoid a recession, a scenario that is not fully priced by the financial markets? Well, in my mind, there are four.

For the Federal Reserve, respectfully, I would strongly urge moving short-term interest rates to 3% before the end of the summer. That would help tamp down inflation expectations, which have started to creep up given the recent experience of high inflation.

We would need to see commodity prices fall further from here. Say, perhaps, oil below $100 a barrel— which, if that would occur, would fully offset the rise in food prices, which have also been material over the past 12 months for most consumers.

If we would see inventories rebuild as they have been doing over the past several months, that would potentially provide some modest price relief, and that is critical to bring down headline inflation, which is north of 8.5%.

And then, finally, we need to see a little bit of luck on labor supply. And, indeed, we would need to see at least one million Americans more join the labor force over the summer. That would help better balance the strong demand for labor with the lack of supply. And that would provide still-heady wage growth, but perhaps at a slightly lower rate and yet still ahead of the rate of cost of living, should we see these three other conditions met.

So, four conditions to avoid recession. And, unfortunately, I don’t view this as a multiple-choice exam, and in fact we would need to see all four met for the U.S. economy and other markets to avoid recession.

So, bottom line: Soft landings, which is the goal of many central banks; soft landings are rare, and they’re rarer than recessions. And should the U.S. economy and other markets fall into recession, that will be unfortunate, although it will not spell the end of economic growth in the future.

The path of the recovery, it has certainly narrowed. But the road isn’t blocked just yet, and in the months ahead we will have a better sense of where the economy unfolds.