Moody's warns that the probability of a U.S. recession within one year is 49%! Exclusive interview with Moody's Chief Economist

Question: How Does the Energy Crisis Worsen the U.S. Economy’s K-Shaped Split for AI?

Moody’s Analytics chief economist Mark Zandi issued a warning in its latest outlook report, “Iran Oil Shock.” He said that the closure of the Strait of Hormuz would not only directly raise U.S. inflation, but would also land a heavy blow at the most vulnerable point in the U.S. economy. Moody’s estimates that the probability of the U.S. economy falling into recession within the next year is 49%, just one step away from the 50% warning threshold.

“All the policies are flying around in the air—trade policy, immigration policy, foreign policy.” Zandi said in an interview with a First Finance reporter, “Washington has released too much drama.”

K-Shaped Divergence and Recession Under an Energy Shock

Zandi believes this energy crisis is a severe blow to American consumers, and that—against the backdrop of a “K-shaped economy”—this blow is taking on extreme, differentiated effects.

“Every time the gas price goes up by one cent, American consumers need to spend an additional $1.4 billion over the course of a year. Put simply, if oil prices stay at their current level, by this time next year Americans will be spending an extra $70 billion at the gas station.” Zandi wrote in the report that if oil prices remain elevated and, given their spillover effects across multiple industries, consumers will need to spend an additional $150 billion next year to buy the same goods and services.

Zandi said that within low-income groups, a larger share of wages will be used for spending on energy and necessities. They are the first batch of victims of the rising oil prices, and the result is a real and tangible loss of purchasing power. According to data from the American Automobile Association (AAA), as of March 24, the nationwide average gasoline price in the U.S. was $3.977 per gallon, up nearly 35% from a month earlier.

By contrast, the top 20% of U.S. income earners—those with annual pay of $175,000 or more—had previously benefited from growth in stock-market wealth, showing strong resilience, and accounted for 60% of all consumption nationwide. But Zandi warned that this wealth effect that supports consumption can be evaporated extremely easily by a stock-market correction: “Right now, the strong consumption power among high-income groups is to a large degree driven by the surge in stock valuations… But if stock valuations get too high, a bubble forms, and then begins to correct, there’s no question that will undermine the positive momentum of consumer spending. At that point, the U.S. economy will be struggling, and it is very possible that it will slide into a recession.”

Over the past month, the cumulative declines in the S&P 500 index and the Nasdaq have been 5.6% and 6%, respectively.

Zandi further analyzed that the surge in cost of living brought by higher oil prices has already fully offset all the benefits expected from the “Big and Better” law. The tax-cut policies that were originally seen as an engine for economic growth have now merely become a patch—“pain relief”—to offset high oil prices. Although the current level of oil production in the U.S. is already sufficient to cover domestic use, under the global pricing system, American consumers still can’t escape it. Because energy producers remain uncertain about how persistent price volatility will be, they are extremely slow in expanding production and hiring. This means the pain from rising oil prices is immediate, while the benefits are delayed and weak.

Zandi emphasized that, with other conditions unchanged, if oil prices average close to $125 per barrel in the second quarter of this year, a recession in the U.S. economy will happen quickly.

The Fed’s “Tight Spot”—Between In and Out

Before the energy crisis arrived, the Federal Reserve was caught between seemingly stable economic growth and an increasingly weak labor market; the oil shock instantly shattered that balance.

Rising energy prices have sparked deep market concern about inflation—and even stagflation. According to the latest Federal Reserve Watch tool from the Chicago Mercantile Exchange (CME), the probability the market expects the Federal Reserve to hold steady through the end of the year is above 70%, and there is even about a 15% chance it will turn toward rate hikes.

A month ago, Zandi had predicted that the Federal Reserve would be able to deliver two to three rate cuts this year. But with the outbreak of the oil crisis, that forecast is now facing the risk of being completely overturned. Zandi said that for every $10 increase in oil prices, it typically contributes 15 to 20 basis points to the inflation rate. If oil prices stay elevated, U.S. inflation later this year could rise to as high as 4%.

And amid extremely volatile economic expectations, the Federal Reserve will enter a highly turbulent transition period led by incoming chair Kevin Warsh. “This is absolutely the most divided one in decades—at least in my memory as a professional economist. I’ve been an economist since 1990, so for 35 years. This will be the Federal Open Market Committee (FOMC) I’ve observed with the most dissent.” Zandi told reporters.

This unprecedented level of disagreement shows not only in judgments about inflation and employment, but also in the challenge of how the incoming chair will take charge of the whole picture. Zandi believes the task facing Warsh is an extremely arduous one: “You can even easily imagine a scenario where there is a disagreement between incoming Fed chair Kevin Warsh and the committee’s final decision—meaning the chair personally casts a dissenting vote against the decisions made by the FOMC. That would be unprecedented. It would not only confuse the market, but also greatly increase market volatility.”

(This article comes from First Finance)