• Bank of America sees a 1-in-3 chance of a US recession next year, but sees a 'bumpy landing' as more likely.
  • If the US does plunge into recession, it will be mild by historical standards, the bank's economists said.
  • They expect the Federal Reserve to hike interest rates by 30 basis points more than the market is pricing in.

Bank of America has warned the US faces a one-in-three chance of tumbling into a recession next year, but said it would likely be mild by historical standards.

The bank's economists said that risks of a recession are low for this year, and they foresee a "bumpy landing" rather than an outright recession as the Federal Reserve tightens financial conditions.

But they're becoming more worried about prospects for the US economy in 2023, given inflation shows signs of persisting and the labor market looks to be seriously overheating.

The US has inflation running at 40-year highs, and the Federal Reserve plans a series of interest rate increases to combat it. But there is concern the central bank could tip the economy into a recession by hiking rates too aggressively.

"Risks are low this year, as the economy has plenty of momentum and it will take time for Fed hikes to impact growth," BofA economists said in a note Friday. 

"However, next year the Fed will be facing some tough choices. We see a roughly one-in-three chance that a recession starts sometime next year."

In May, the central bank raised interest rates by 50 basis points, the biggest increase at one meeting in 22 years, and signaled that similar hikes would follow. 

As the Fed lifts interest rates to 3.4% by May next year, there will be an ongoing slowdown in the economy, according to BofA. They see growth falling to 0.4% by the last quarter of 2023.

"We expect the Fed to hike by about 30 bps more than what is priced into the market, adding a bit further pressure on financial markets," the bank said. 

"The lag from financial tightening to weaker growth is likely to be a bit longer than normal, causing gradual downward pressure on growth," they added.

The US stock market has logged a string of weekly losses as investors fret about the risk of stagflation and recession. Sentiment has dropped to "extreme fear" levels, according to CNN's Fear and Greed index, as business leaders from Tesla CEO Elon Musk to Goldman Sachs CEO David Solomon sound the alarm on growth.

Market historian Jeremy Grantham has predicted stocks could fall as much as 80% from their peaks in a coming recession, though JPMorgan's quant guru Marko Kolanovic believes the market is pricing in too much risk.

"If the economy does tumble into a recession, it will likely be mild by historic standards," BofA said. "The economy has relatively few imbalances, and hence the risk of ugly feedback loops kicking in is lower than normal."

It laid out three reasons why the US could avoid an outright recession. The first is that the economy has only one big imbalance — an overheating labor market.

In April, the US unemployment rate was 3.6%, and businesses struggled to hire staff, with the number of Americans actively looking for jobs stuck below pre-pandemic levels. BofA expects the rate to fall to 3.2% next year.

That labor shortage means employers must pay higher wages to recruit staff — which feeds into inflation.

Given that, the Fed will have to push the unemployment rate back up in 2023 and 2024, according to BofA. Their baseline case calls for a 1% rise to do the trick, or 2% in a recession.

"Second, we don't think the Fed has to do all the work in raising the unemployment rate: workers returning to the job market will help," they said.

The third reason is they see the Fed as relatively dovish, and believe it will stop hiking rates once the unemployment rate starts rising and underlying inflation falls to to 3%, rather than to its 2% target.

Read more: Goldman Sachs lays out the case for investing more of your money in real assets — and reveals which ones it's most bullish on as the stock market crashes

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