Will the United States and Europe enter recession in 2023? Here’s how to be careful when the economic outlook doesn’t
At the end of the year, the usual flow of economic prospects is in full swing. Many prospects are looking for something to break in the economy, but the most obviously broken thing is the economic prospect itself.
The outlook for 2020 was quickly dismantled by COVID and the outlook for 2022 was destroyed by Russia’s war in Ukraine, but it’s not just exogenous shocks that are undermining the outlook. As the economy took the hits this year, prominent voices spoke of economic “hurricanes” or prematurely declaring that the United States was in recession. However, at the end of the year, we see an economy with many strengths, even if the macroeconomic headwinds remain exceptionally strong.
If perspectives fail so often, how can we plan for 2023? Rather than wondering whether there will be a recession, executives and investors would do better to wonder what would cause it. Moving from point forecasts to frameworks organizes risks, envisions multiple future scenarios, and prompts us to react more calmly when shocks occur. No framing is a crystal ball. It may not reduce the very real risk of recession, but it may provide more nuance than the gloom that has let down many forecasts in 2022.
How prospects falter
Shocks naturally remain the biggest challenge for forecasts, but they can also reinforce them. Consider those who predicts a surge in inflation in early 2021 because of too much monetary and fiscal stimulus. This prediction deserves credit. However, it was later aided by sputtered supply chains and energy prices have risen above pre-pandemic levels, not to mention Putin’s subsequent war in Ukraine which pushed energy prices even higher. It is clear that a sequence of shocks widened inflation and delayed its peak.
Another bane of forecasts is the temptation to extrapolate the latest macroeconomic data release, linking sentiment to the forecast. Consider how the confluence earlier this year as geopolitical conflict, rising interest rates and weak GDP data weighed on sentiment. Jamie Dimon, CEO of JP Morgan Chase, memorably captured the mood when he said the economy was going to take a hit. “hurricane,” a statement eagerly echoed in the headlines of the premature recession.
Both examples highlight that while the value of a forecast is often perceived as hitting the target, its greatest value is in identifying and communicating the drivers at play.
Abandonment of forecasts for executives in 2023
Dwight Eisenhower said that “plans are useless, but planning is essential”. It is not the predictions that are valuable, but the process that exposes the drivers, risks and multiple outcomes.
Specifically, leaders should not ask will the recession comebut what it would take to land in it, shift the perspective from results to engines. A high-level recession framework emphasizes three paths to recession.
First the real economy (consumers and businesses) can lead us into recession when shocks shake their confidence, halt their spending and cancel their investment plans. Although a very large shock destroys the strongest of economies (think COVID lockdowns), that usually means weighing the size of a shock against the dominant force in the economy. Some shocks will be absorbed, and although downturns in the real economy can be significant, they are usually not structural turning points, allowing economies to rebound their previous tendency.
Second, monetary policy makers can drive economies into recession. Political recessions occur when central banks raise rates too quickly, too far, or for too long, tightening financial conditions and stifling the economy.
When the alternative is an even bigger inflation problem, a hard landing can be a intentional and wise choice. There is little precision in the policy tools that allow for a graceful slowdown in growth and prices. When policymakers raise rates, the brutality of their instrument means they are also increasing the risk of recession.
Third, financial recessions may occur after the bursting of financial bubbles or a shock that hampers the banking system. They are usually the worst kind of recession because they can cause lasting damage to balance sheets and credit intermediation, requiring slow rebuilding. The 2008 global financial crisis and the 2011 European sovereign crisis were financial recessions, but not all recessions (or recoveries) are equally painful.
The recession of the real economy in Europe
What does this framework say about 2023? Although global energy prices are a headwind for the US economy, it is in the eurozone that a bigger shock has likely pushed the most vulnerable economies into recession. The question is how deep and how long a downturn might be.
Much of the intense gloom of 2022 failed to materialize as macro data generated a series of modest positive surprises. Many European companies have shown their resilience. In the third quarter, German industrial production was in line with 2021 levels using ~10-20% less natural gas.
Will 2023 bring any more upside surprises, or has the demise just been pushed back on the timeline? Many commentators have opted for the latter, suggesting that the breakout this winter has simply delayed gloomier results until next year.
A recession in the real economy cannot be ruled out, especially if the energy shock intensifies or if a new shock occurs. In the absence of these, the real economy could continue to surprise. Businesses still have significant investment needs and they have the capacity to do so. Meanwhile, the European labor market remains tighter than it has been for many years.
For those looking for negative European narratives, a growing risk lies in the second type of recession, the political recession. So far, European inflation has been largely linked to energy prices, something over which the ECB has no influence, resulting in a less aggressive rise in interest rates. If inflation widens, like the much larger problem in the United States, monetary policy could become a second engine of recession in the eurozone.
America’s “curse of strength”
The United States continues to face a rather different set of risks in 2023. Rather than a faltering real economy, American businesses continue to hire and households continue to spend. Calls for recession were wrong this year. However, every sign of strength is a problem for the US economy because it fans the flames of inflation and pushes the Fed toward even more aggressive policy.
Although headline inflation appears to have peaked with a significant decline from its peak in June, price growth remains far too high and the path to an acceptable pace is far from certain. Even if the pockets of price pressure ease, without a slowdown in the labor market – and with it wages – price growth will remain too fast.
That said, the inflation problem in the United States is not one that calls for a deliberate forced landing while long-term inflation expectations remain contained. However, slowing the labor market with the blunt tool of the policy interest rate – with its long and variable lags – is a difficult maneuver. The first signs of the journey have had encouraging signs, but there is still a long way to go. Monetary policy could remain a drag on growth for years.
The risk of financial crisis
As interest rates have risen rapidly, the possibility of something going wrong in the financial system increases, making it imperative to consider the third type of recession as well.
Financial markets – ranging from traditional asset classes to alternatives to exotics – delivered a sickening performance in 2022 as shocks disrupted markets and policymakers slammed breaks. Reassuringly, the tightening of financial conditions has been driven primarily by falling valuations and volatility, which are less systemically threatening than a tightening driven by funding or credit risk.
Although this suggests that a financial crisis is not underway, rising rates, especially after a long period of extraordinary ease, increase the risk of financial crashes. Today, the visible signs of an emerging balance sheet problem are hard to spot. Delinquencies, write-offs and bankruptcies remain modest. Credit spreads remain compressed. And capital ratios remain healthy. However, conditions are increasingly prone to accidents – we can never rule out the financial risks.
The world will remain weird in 2023
Seeking the value of planning – rather than plans – is even more important today, as the economic environment continues to be exceptionally unusual, not to mention looking more shock-prone.
The economy is still adjusting to the pandemic shock and subsequent policy response. New complications created by a clash of tailwinds and headwinds (strong labor markets, geopolitical energy shocks and aggressive policy tightening) make it unlikely that we will enter calm waters soon.
However, barring overwhelming new shocks, the road ahead need not be as bleak as often painted. The recession in Europe has a chance of avoiding the most damaging outcomes while turning cyclical weakness into structural strength: monetary policy can permanently escape negative interest rates, the labor market can remain tight and the investment can strengthen to tackle structural challenges, three areas where Europe has faltered in the past.
In the United States, the cyclical path still contains a plausible “soft landing”, an outcome where job creations decline while the unemployment rate remains low, although a recession is also likely.
The challenge for the United States and Europe is that there is a long way to go. Europe will live in the shadow of a geopolitical energy threat and the easing of cyclical tensions in the United States will take time. These are dangerous and unpredictable paths that require not just a plan, but a lot of planning.
Philipp Carlsson-Szlezak is managing director and partner in BCG’s New York office and the firm’s chief global economist.. Paul Swartz is Director and Senior Economist at the BCG Henderson Institute in New York.
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