Before Russia’s Feb. 24 invasion of Ukraine, the outlook for the U.S. economy was stressed but hopeful. Pandemic pressures appeared to be peaking, inflation was widely expected to normalize, and the Fed stood a credible chance of engineering a “soft landing.”
But an enormous humanitarian atrocity in Europe has triggered an unpredictable global financial and economic conflict that will see consequences ricochet. Though new risks have emerged, and uncertainty is higher, at present the main impact of the crisis on the U.S. economy is the exacerbation of existing pressures and risks. The path of inflation, and the policies to contain it, remain the main threat to the cycle. While that risk has gone up, it need not be a recessionary outcome.
How the Stimulus Bet Played Out
As we wrote here last year, policy makers placed an enormous bet at the start of 2021 that extraordinary stimulus would transform a strong recovery into an even stronger expansion. The payoff would be a “tight” economy — one that delivered broad-based real wage gains that firms paid for with higher productivity growth, not by raising prices. A win-win-win for workers, firms, and politicians.
That preferred scenario has not materialized. The tight economy did arrive with strong nominal wage gains and signs of productivity growth. But inflation has grown faster, as firms discovered pricing power and used it widely to protect their profit margins. In February, year-over-year price growth stood at 7.9%, a 40-year high.
But it would be wrong to blame only the stimulus. Inflation was also driven by supply-chain bottlenecks — exacerbated by waves of the virus that interrupted production and slowed inventory recoveries — and a labor market scrambling to hire back workers, while labor supply sluggishly continued to normalize.
Pressures Appeared to Have Peaked
Despite this, there was clear evidence that the U.S. economy had passed peak economic pressure. In product markets, demand was normalizing, even slowing in many overheated areas, such as consumer durables, while inventories were growing. In the labor market, the frenetic pace of hiring had eased, while labor supply was finally normalizing.
February’s job reports, released on March 4, underlined all this. Firms were broadly able to hire workers in large numbers (+654K private payroll), which was facilitated by a continued strong uptick in labor participation. Meanwhile, wage growth, though still high year over year, was flat month over month. All this would have been a bullish signal that the economy remains strong and pressures were easing.
How the War Drives up Recession Risk
Russia’s conflict has made those markers of economic strength nearly irrelevant as higher-order risks are taking center stage. The prospect of sustained conflict and an altered geoeconomic reality have yet to sink in. But it’s not too early to think about how the impact could play out. Is a recession now in the cards?
The impact of an economic shock is delivered through one — or several — of three transmission channels. Let’s see where risks are highest and why.
Financial recessions remain the pernicious kind. They unfold when a shock cripples banks, either through liquidity or capital concerns that force them to deleverage. In their wake, they leave lasting asset price damage, impaired investment plans, and slow recoveries. This was the story of 2008 — but it was successfully averted in 2020.
The U.S. banking system was in strong shape before the war started and continues to exhibit very limited stress. The capital position of U.S. banks is strong, profitability is the best it’s been in years, and liquidity is extremely flush. Exposure to Russian assets is limited, and live data on credit spreads are reassuring.
Yet, there remain unknowns. Banking is an extremely interlinked ecosystem, which can hide vulnerabilities. A novel risk that stands out is a debilitating cyberattack on western financial infrastructure, a clear reason never to dismiss the financial sector as a source of serious surprise.
Real economy recessions are typically milder and driven by sudden demand or supply shocks that can tip an already vulnerable economy into recession. Has the Ukrainian conflict triggered enough headwinds to deliver such a shock? On the negative side of the ledger a few stand out:
- Energy prices (direct effects): In 2021, oil prices in the U.S. (WTI) rose from just below $50/barrel to more than $75/barrel. If prices had stayed there, the impact on inflation (and real incomes) would have waned, as inflation measures the change in prices, not price levels. However in the wake of the Ukraine invasion, prices have as high as $130/barrel, i.e. similar price growth to last year’s and hitting real incomes again.
- Energy prices (impact on confidence): Energy prices also have a clear — inverse — relationship with consumer confidence. Consider that confidence didn’t recover strongly in the last expansion until oil prices collapsed throughout 2014. High oil prices flowing through to the gas pump are likely to diminish household confidence.
- Wealth effects: Falling asset prices mean households feel less wealthy and make them pull back from expenditures and save more.
- Supply-chain disruptions: Russia’s invasion is another blow to globally integrated supply chains that have repeatedly gummed up economic output over the last two years.
Despite this litany of headwinds, it’s not clear as of today that they outweigh the tailwinds the U.S. economic cycle continues to experience:
- Growth, though decelerating, has momentum and is running above trend growth in 2022, providing some insulation from shocks.
- Household sector remains healthy, as balance sheets are still very strong across income cohorts, including elevated cash balances.
- Labor markets are very tight, with record job openings, strong hiring, and strong wage gains providing a robust domestic tailwind to continued consumption.
- Firms remain highly profitable and interested in investing, as they look to build resilience and new capacity.
- Direct U.S. trade linkages to Russia and Ukraine are modest overall, and potential disruptions will come as Americans continue to reemerge from Covid shutdowns.
These tailwinds and headwinds are not exhaustive, nor is it possible to confidently net them against each other. But the backdrop of the U.S cycle remains one that suggests the expansion can continue.
A Policy Error Remains the Central Recession Threat
This means the most plausible source of risk remains a so-called policy error recession. Even before the war, a policy error was the key risk to the expansion: Hike interest rates too little or too slowly and inflation may spiral out of control; hike rates too high or too fast and an unnecessary recession occurs.
The war has made the Fed’s high-wire act even more precarious. To get the balance of headwinds and tailwinds right, policy makers have to interpret all the drivers we discussed so far — energy, labor markets, product demand, supply chains, etc. — without having full visibility or timely data. The impact of energy prices, for example, was difficult enough to gauge before the war. Now it’s gotten a lot harder, and so the risk of a policy error is also a lot higher.
Before the invasion, markets saw the Fed delivering seven interest rate hikes through the beginning of 2023 to bring inflation under control. Many observers feared that would be too much for the cycle to survive. Today, the market still sees about seven hikes — basically unchanged despite the massive increase in uncertainty. The key question is not if the war derails the expansion, but if the Fed can negotiate a soft landing with that degree of tightening.
What Executives Can Do
As the shock of the invasion reverberates through the economy and cycle risk builds, executives will strive to position their businesses to minimize impact. Here are a few do’s and don’ts.
- Don’t rely on forecasts as extreme uncertainty prevails; flimsy in the best of times, they remain out of reach.
- Do build the capabilities to analyze and model the transmission of shocks and stress test using scenario planning.
- Don’t assume that shocks deliver structural change – they can, but in the fog of the moment the bar for inflection often appears deceptively low.
- Don’t assume that pricing power persists. As growth moderates and inventories build, firms may well return to defending market share.
- Do think of productivity growth as a sustainable source of competitive advantage.
Russia’s invasion of Ukraine occurs just as pressures in the U.S. economy peaked, and prospects of a soft landing were good. The days, weeks, and months ahead will bring more clarity about how it impacts the U.S. economic cycle. A recession is not a foregone conclusion, and companies should stay flexible, reassessing their outlooks and tactics as events unfold.