Why We Can’t Shake Recession Fears
Despite some recent strength in the U.S. economy, we’re still preparing for a downturn
At the beginning of 2023, recession fears were on everyone’s mind. Inflation, though down from its peak, was still far above the Federal Reserve’s 2% target, job growth seemed to be slowing from its white-hot pace, and the Fed continued to raise interest rates. Abroad, geopolitical turmoil persisted and the global economy’s post-pandemic normalization remained uneven. Still, despite these headwinds, the U.S. economic growth across the first half of 2023 has been better than expected. Consumer spending has remained resilient and employment has continued to increase. All in all, the U.S. economy does not appear to be in recession currently. But some cracks are developing.
At a high level, the U.S. economy has been generating a nominal GDP growth of roughly 6% recently, but (unfortunately) the mix has been 2% from real growth and 4% from inflation. That looks unstable to us, since the Federal Reserve is an institution which, by mandate, is tasked with fighting excessive price changes. Their target is 2% consumer inflation, which we are well above currently by almost any metric.
This gets us back to the main reason for our concern about an economic downturn, which is the same as it was at the start of the year: an imbalanced U.S. economy. The goal of economic policy is to help balance supply and demand. Unfortunately, many global economies have found it difficult to achieve this type of balance over the past three years. There have been very large shocks to the system, due to both health concerns and geopolitical events. Ultimately, demand exceeding supply has generated the largest spate of U.S. inflation in the past 40 years.
All in all, the U.S. economy does not appear to be in recession currently. But some cracks are developing.
Of course, the Fed does not control the supply side of the economy. They cannot plant more crops, build more houses, or pump more oil. And if supply will not increase to meet demand, then demand must fall to meet supply. To influence demand in the economy, the Fed can raise or lower interest rates to make borrowing cheaper or more expensive. But bringing demand down a significant extent is another way of saying the economy will be in recession. That is ultimately why Fed hiking cycles have often led to recessions in the past – higher rates lead to lower demand and higher risk of recession.
We’ve already seen significant policy tightening. As of mid-year, the Federal Reserve had raised interest rates ten times over 15 months, taking the bank’s key policy rate from 0% to 5%. Central banks around the globe have largely followed suit with tighter policy of their own. And while we are likely near the end of the Fed’s hiking cycle, monetary policy generally acts with a lag, so today’s actions will continue to impact the economy in coming years. Even if we have gotten past the bulk of the rate hikes, we are not past the effect of these policies.
And so, it should not be surprising that despite economic resilience in the U.S., there are some cracks developing. The U.S. housing market has slowed significantly in the past year. The local manufacturing sector has moved into contraction territory based on some timely data. There have also been several high-profile bank failures in 2023. Abroad, the German economy has already seen two consecutive quarters of negative real GDP growth (a common definition of recession), while economic activity in China has also been disappointing despite the initial optimism for a post-Covid boom in 2023.
Further, according to senior loan officer surveys, banks have begun generally tightening their lending standards. This area is under particular scrutiny due to the U.S. banking turmoil earlier this year, and tighter lending standards have historically been a leading indicator of permanent job loss. Thus far, we have seen a slowing in the growth of employment, but not outright declines in key data such as U.S. nonfarm payrolls. Unfortunately, we believe there is still weakness to come.
On a more optimistic note, there are several cushions that could help limit the damage. There is still some excess cash saving left over from the pandemic-era fiscal stimulus, and the U.S. labor market remains extremely tight (to the extent that there are roughly 1.6 job openings for every unemployed person). The Fed’s hope is that they can remove job openings from the system, thereby bringing down wage growth, without destroying too many actual jobs.
But the bottom line remains: Wringing inflation out of the system is unlikely to be painless, and we believe risks to economic growth currently skew to the downside. As we like to remind our clients, history teaches us that inflation should be symmetrical – the steeper the increase in price pressure, the steeper the decline on the back end. This should remain the underlying trend in 2023 and 2024: with restrictive monetary policy in place, inflation should come down and the Fed will eventually feel less urgency to fight inflation. But, given what the Fed has done to get there – and what they may have left to do – the cost is likely to be a decline in U.S. job counts and an eventual recession.
