Why the U.S. could still see a mild recession this year

Bank of America Chief Economist Michael Gapen joins Yahoo Finance Live to explain why he still sees a mild recession for the U.S. economy this year. Gapen explains that "some corrections of imbalances in the labor markets" will be needed to bring inflation down to the Fed's 2 percent inflation target.

Video transcript

JULIE HYMAN: Well, as investors continue to digest May's jobs numbers and move on to the much anticipated Fed decision next week, our next guest says while the Fed could skip a hike in June, another rate hike cannot be ruled out. Michael Gapen is Bank of America chief economist. He's joining us now. Michael, thanks for being here.

You know, whether you take the jobs report or what have you, I guess what's surprising is the tenor and the discussion around the economic data seems to have improved. But as we were just pointing out, the market is not quite there on re-entering a bull market. Do you think we have a perception gap right now between the actual data and how it's been perceived?

MICHAEL GAPEN: No, I don't think so. I think you're exactly right in terms of the tenor of the discussion around the macro data has improved. That's in part because risks have been reduced. We've gotten past the debt limit. It looks like the bank stress situation is in stasis. It's not getting a lot better but it's not getting materially worse.

And underneath that, the employment and other spending data show an economy that's generally resilient. But I think if you're discussing and debating whether equities are on the edge of a bull market, I think that generally means equity prices are reflecting that broader macro backdrop. I don't think there's much of a disconnect, in my opinion.

BRAD SMITH: We've been following all of the moves of the CME Fed watch tool in whether or not there will be a rate hike or not at the next meeting. Is the data suggesting, from your perspective, that there needs to be one solid decision or another from the Fed?

MICHAEL GAPEN: I think that the decision-- I mean, it's tough for them right now because they have said, hey, we've done a lot, and we've done a lot fast by historical perspectives. And what we'd like to do is take the opportunity to look around a bit and assess those lags and assess bank stress and see where the economy is going and make a decision if we need to do more. It's pretty clear they're starting to lean in that direction.

As I mentioned, risk's receding a bit. Banks are stabilizing the macro data. Generally looking good. They've been communicating that, hey, maybe we do have a little more work in front of us. So the trick will be, how do you-- how do you balance that message next week? Have you seen enough to tell markets you're ready to do more but just not in June? It's a tricky message to deliver.

JULIE HYMAN: Yeah, and as we know, sometimes it's tough with that kind of nuance for the Fed-- for anyone, but for the Federal Reserve where there is so much attention on them. The backdrop for this, of course, is economic growth, whether we're going to enter recession this year. Where are you on that calculus right now, Michael?

MICHAEL GAPEN: I mean, we're still in the mild recession camp later this year. But about as strong as we've ever been on that is to say we think it's just more likely than not. We've never really firmly pounded the table on that other than to say, look, we think some correction of imbalances in the labor markets ultimately will be needed to bring inflation down to 2%.

And normally, that does look like an NBER-defined recession at some point. But we've been-- at the same time, we have to acknowledge where the data flow is, and that's always been in the direction of resilience. You can't rule out a soft landing. But yes, we think more likely than not, we will have that correction in the labor market later this year.

BRAD SMITH: And so the labor market, usually kind of the last to realize that we're in a recession. So does that mean that we'll be in a mild, from your perspective, or a more severe type of recession experience?

MICHAEL GAPEN: I think mild. I think-- and I define mild as something less severe than the average recession. So for example, a peak-to-trough decline in GDP and closer to 1.5% would be where the average downturn has been. I think our peak-to-trough decline rounds up to 1%. So we're maybe half as severe as the average recession.

And this is, in part, why using the R word sometimes is a little misleading. There's not a major difference from a macro and markets perspective from a mild recession and a soft landing, and I think that's what financial markets are telling you. So unless bank stress gets worse and a credit crunch is revealed, it's harder to see where that hard landing risk is coming from at present.

JULIE HYMAN: There is an interesting note out this morning, Michael, from your peers over at Goldman Sachs, who said because we avoided the debt ceiling situation, they sort of ratcheted down their chances of recession this year. I think they're putting it at 25%. You know, I would like to never discuss the thing again, but I am curious if that changed your models at all.

MICHAEL GAPEN: No, it didn't. Our view was always we would get an agreement at the very last minute or maybe one to two to three days after the actual X date was reached. We did feel it would run right up to the very end, but-- but we always had an agreement in our baseline. And I think what we just discussed really as part of the debt limit agreement were the budget caps we would have had to discuss under the budget at the end of September, at the end of the fiscal year. So we just brought that discussion forward.

And again, in divided government, about what you're going to get is what we got. So this really for us was really no change in terms of our view on fiscal policy. We felt it would be neutral in terms of contributions to the outlook going forward. And maybe taking a breather on fiscal spending after three years of a lot of spending is the right idea.

BRAD SMITH: We've continued to hear another R word, especially from some of your peers at other banks over the course of the earnings season-- resilient-- and saying that the consumer's healthy and resilient. What type of resiliency are we seeing in the consumer right now in comparison to periods prior to other recessions in the past?

MICHAEL GAPEN: Right, yes. As you know and as has been discussed often over the last few years, this is a very different business cycle, a very different recovery. And there's still a lot of support for the consumer, from strong labor markets, from deferred and excess saving as well as wealth effects. And I don't think household balance sheets probably get enough discussion in this conversation.

From trough to peak during COVID, household balance sheets added over $33 trillion in net worth, so more than one year's worth of GDP and financial prices as well as home prices. All three of those are still supporting spending. They're supporting spending less than they were in the past, and credit conditions have certainly tightened, and the cost of credit has risen, so that's a headwind. But I still think there's tailwinds there that are showing through and keeping the economy in an expansion phase and leaning the Fed in the direction of thinking it still needs to do more.

JULIE HYMAN: Yeah, we're going to continue to watch those loan officer surveys very carefully, Michael. Michael Gapen is Bank of America chief economist. Thanks so much.