Downside Risk Scenario: Roller Coaster

Genevieve Signoret & Delia Paredes

(Hay una versión en español de este artículo aquí.)

What follows is a slightly edited excerpt from Quarterly Outlook 2023–2025: It All Hinges on Rates.

Yesterday, we narrated our base case, Soft Landing. Today, we narrate our pessimistic scenario, Roller Coaster. Forecast tables for both cases are found here.

Roller Coaster Assumptions

Ever since the Fed started to hike rates rapidly, analysts have been warning the “something might break”. In our pessimistic scenario, Roller Coaster, we assume that inflation and rates will stay high for longer than in Soft Landing. We further assume that what breaks first are home prices and the residential construction sector, with dire effects on jobs.

Roller Coaster Forecast Narrative

The United States

Next year starts out strong in our Roller Coaster scenario, with annualized GDP growth rates accelerating all the way to 4.2% in quarter three from a forecast 1.8% for the final quarter of 2023.

But the forces pushing up growth push up, additionally, on prices and long-term rates—so much so that the Fed in fact raises rates again in quarter two.

Things start to break in quarter four of next year, however, as house prices dive, and the construction sector crashes. Growth for 2024 overall slows down to 1% and the economy sinks into recession in 2025.

Core inflation dips below 2%, with the Fed lowering its policy rate all the way to 1.50%.

Mexico

Economic activity in Mexico in this scenario receives an extra boost from strong U.S. growth during the first three quarters of next year. But it decelerates sharply at end-2024, bringing the rate for the entire year to 2.8%.

In 2025, the recession in the United States and the negative fiscal thrust in Mexico push the economy into its own recession. Activity contracts by around 0.3%.

Inflation in this scenario hovers around 4.8% for most of next year, on higher levels of core inflation driven by persistent upward pressure on demand. In 2025, it falls back to 3.8%.

The central bank, in tandem with the Fed, reluctantly hikes its policy rate by 25 basis points to 11.50% in quarter two of 2024 and only thereafter starts easing its stance. By end-2025, the policy rate is down to 7.25%.

The path of dollar–peso rates in this scenario is similar to that laid out in Soft Landing.

Previous excerpts from Quarterly Outlook 2023–2025: It All Hinges
on Rates:

1. Summary
2. Long-term rates and equity valuations
3. Rates, Covid and real estate valuations
4. Why have US long-term rates trended up? Hypothesis 1: Debt issuance
5. Why have US long-term rates trended up? Hypothesis 2: Tight policy
6. Why have US long-term rates trended up? Hypothesis 3: Investor inflation worries
7. Why is US nominal income unexpectedly high?
8. Momentum: Recap
9. What about growth in Mexico?
10. Soft Landing Scenario Assumptions
11. Soft Landing Forecast Narrative