Will the US and Europe slip into recession in 2023? Here’s how to watch out when the economic outlook isn’t | Bot To News


As the year draws to a close, the usual flow of economic outlook is in full swing. Many views look for something to break in the economy, but the most obviously broken thing is the economic outlook itself.

The outlook for 2020 was quickly dashed by COVID, and the outlook for 2022 was slashed by Russia’s war in Ukraine – but it’s not just exogenous shocks that are undermining the outlook. As the economy took a hit this year, prominent voices spoke of economic “hurricanes” or prematurely declaring the US into recession. However, at the end of the year, we are looking at an economy with a lot of strength, although macroeconomic headwinds remain extremely strong.

If prospects fail so often, how can we plan for 2023? Rather than wondering if there will be a recession, executives and investors are better off asking what would cause one. Moving from point forecasts to frameworks organizes risks, considers more future scenarios, and grounds us for a more calm response when shocks strike. No framing is a crystal ball. It can’t reduce the very real risk of a recession – but it can achieve more nuance than the gloom that disappointed many forecasts in 2022.

How the views sway

Shocks, of course, remain the biggest challenge to forecasts – but they can also strengthen them. Consider those who predicted a jump in inflation in early 2021 due to too much monetary and fiscal stimulus. This prediction deserves recognition. However, he was later helped by fragmented supply chains and energy prices that exceeded pre-pandemic levels, not to mention Putin’s subsequent war in Ukraine, which sent energy prices even higher. It is clear that the sequence of shocks increased inflation and delayed its peak.

Another bane of forecasting is the temptation to extrapolate from the latest macro data release to bridge the sentiment in the forecast. Consider how the confluence earlier this year as geopolitical conflict, rising interest rates and soft GDP data affected sentiment. Jamie Dimon, chief executive of JP Morgan Chase, memorably captured the mood when he said the economy was about to experience a “hurricane”, a statement eagerly taken up by headlines of a premature recession.

Both examples highlight that while the value of forecasting is often perceived as achieving a goal, its greater value is in identifying and communicating the factors at play.

Dropping the forecast for the 2023 framework

Dwight Eisenhower famously said that “plans are useless, but planning is indispensable.” It is not a valuable prediction, but a process that reveals drivers, risks and multiple outcomes.

Specifically, management should not ask there will be a recessionbut what would it take to land in one shifting the perspective from outcomes to drivers. The high-level recession framework highlights three paths to recession.

First time, real economy (consumers and businesses) can lead us into a recession as shocks shatter their confidence, halt their spending and undo investment plans. Although a very large shock will wipe out the strongest economy (think of the shutdowns due to the COVID disease), this usually means that the size of the shock must be weighed against the prevailing strength of the economy. Some shocks will be absorbed, and although recessions in the real economy can be significant, they are usually not structural turning points that allow economies to return to their previous trend.

Second, monetary policy makers they can lead economies into recession. Political recessions occur when central banks raise interest 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 crash landing can be a planned and sensible choice. Policy tools to gracefully slow growth and prices are a bit imprecise. When policymakers raise interest rates, the openness of their instrument means they also increase the risk of a recession.

Third time, financial recessions it can occur after the bursting of financial bubbles or a shock that shakes the banking system. They are usually the worst type of recession because they can cause permanent damage to balance sheets and credit intermediation, requiring a slow recovery. The global financial crisis of 2008 and the European sovereign crisis of 2011 were financial recessions – but not all recessions (or recoveries) are so painful.

Recession of the European real economy

What does this frame say about 2023? Although global energy prices are a sharp headwind for the US economy, the eurozone is where the bigger shock is likely to push more vulnerable economies into recession. The question is how deep and long the fall can be.

Much of the intense gloom of 2022 failed to materialize as macro data produced a series of modest positive surprises. Many European companies have shown their resilience. By the third quarter, German industrial production was in line with 2021 levels while using about 10-20% less natural gas.

Will 2023 bring more such positive surprises, or is the collapse just pushed back on the timeline? Many commentators have opted for the latter, suggesting that the breakout this winter simply postponed darker outcomes until next year.

A real economic recession cannot be ruled out, especially if the energy shock intensifies or a new shock occurs. Without these, the real economy may continue to surprise. Companies still have significant investment needs and have the capacity to do so. Meanwhile, the European labor market remains tighter than in recent years.

For those looking for negative European narratives, the growing risk lies in another type of recession, a policy-driven recession. European inflation has so far been largely dependent on energy prices, which the ECB has no influence on, resulting in less aggressive rate hikes. If inflation were to spread, like the much broader US problem, monetary policy could become the second driver of recession in the eurozone.

America’s “Curse of Power”

The US will continue to face a much different set of risks in 2023. Instead of a buoyant real economy, American businesses continue to hire and households continue to spend. This year the recession calls were wrong. However, any sign of strength is a problem for the U.S. economy because it fuels the fires of inflation and prompts the Fed to take an even more aggressive policy path.

Although headline inflation appears to have peaked with a substantial decline from the peak in June, price growth remains far too high and the path to an acceptable pace is far from certain. Even as price pressures ease, without a slowdown in the labor market—and thus wages—price growth will remain too rapid.

Nevertheless, the inflation problem in the US is not one that requires a deliberate crash, as long-term inflation expectations remain limited. However, slowing the labor market with the blunt instrument of the policy rate – with its long and variable lags – is a difficult maneuver. The early signs of the journey have had some encouraging signposts, but there is still a long way to go. Monetary policy may hamper growth for years to come.

Risk of financial crisis

Since interest rates have been growing rapidly, the possibility of something breaking down in the financial system is increasing, so it is imperative to consider the third type of recession.

Financial markets — from traditional asset classes to alternative and exotic — have underperformed in 2022 as turmoil rocked markets and caught policymakers off guard. It is of some comfort that the tightening of financial conditions has been driven primarily by falling valuations and volatility, which are less systemically threatening than funding- or credit-risk-driven tightening.

Although this suggests that a financial crisis is not underway, rising interest rates, especially after a long period of extraordinary ease, increase the risk of financial disasters. Today, visible signs of an emerging balance sheet problem are hard to spot. Delays, debits and bankruptcies remain modest. Credit spreads remain tight. And capital ratios remain healthy. However, the situation is increasingly prone to disasters – we can never ignore financial risks.

The world will remain strange in 2023

Finding value from planning – rather than plans – is even more important today, as the economic environment remains extremely volatile, not to mention seemingly more prone to turmoil.

The economy is still adjusting to the shock of the pandemic and the resulting policy response. New complications arising from the collision of tailwinds and headwinds (strong labor markets, geopolitical energy shocks and aggressive policy tightening) make it unlikely that we will enter calm waters any time soon.

However, barring new strong shocks, the road ahead is not necessarily as dark as it is often portrayed. The European recession offers an opportunity to avoid the most damaging outcomes while building cyclical weakness on structural strength: monetary policy can permanently avoid negative interest rates, the labor market can remain tight, and investment can be strengthened to address structural challenges, three areas where Europe has faltered in the past.

In the US, the cyclical path still contains a likely “soft landing,” an outcome where job openings decline while the unemployment rate remains low, although a recession is also likely.

The challenge for the US and Europe is that we have a long way to go. Europe will live in the shadow of a geopolitical energy threat – and cyclical anxiety in the US will take time to ease. These are dangerous and unpredictable routes that require not only a plan, but a lot of planning.

Philipp Carlsson-Szlezak is a managing director and partner in BCG’s New York office and the firm’s global chief economist. Paul Swartz is a director and senior economist at the BCG Henderson Institute in New York.

Opinions expressed in Fortune.com comments are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Luck.

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