The Federal Reserve has a blunt yet effective instrument to fight inflation: raising the federal funds rate. But using it requires a delicate balancing act.
Are we in a recession? No. But we have revised down our forecast for growth for this year to 1.5%, with the risk of a slower pace.
In the best-case scenario, the Fed, by raising rates, reduces discretionary spending enough to stabilize prices, and the economy continues to grow. But in the worst-case scenario, economic growth comes to a screeching halt as spooked consumers rein in spending, and the economy tumbles into recession.
To be sure, the Fed is not alone in trying to restore price stability. Fiscal policymakers can deploy tools like automatic stabilizers—think of unemployment insurance—which can offset sudden changes in the economic cycle.
But some of these policies require legislative approval, which is difficult to achieve in a highly polarized social and political environment. For this reason, we expect the current pattern of the gradual deceleration of economic growth to continue into the next year and for the Fed to operate largely on its own on the path toward price stability.
The Fed’s interest rate hikes translate into an increase in the cost of credit, a slowdown in consumer demand, and ultimately reduced demand for labor.
The human cost is an increase in the number of out-of-work people and challenges for low-income households already trying to make ends meet.
To be clear, the economy is not currently in recession. Real gross domestic product growth over the past four quarters has been 4.9% higher than in the third quarter of 2020, 5.9% higher than in the fourth quarter of 2020, 3.5% higher than the first quarter of 2021, and 1.6% higher than in the second quarter of 2021.
And though surveys by the Institute for Supply Management show that growth in the manufacturing sector and the service sector has receded over the past six months, the reality is that the rapid growth last year, in the post-recession months, was unsustainable and bound to return to earth.
These days, we have an economy buoyed by roughly $2.2 trillion in excess savings accumulated during the pandemic, a robust labor market, and strong, fixed business investment that continues to bolster a growing economy.
But we cannot ignore rising retail and wholesale inventories and the soaring costs that are impeding the ability of firms and households to sustain that growth. For this reason, we have revised down our forecast for growth for this year to 1.5%, with the risk of a slower pace.
The figures that follow should help explain our viewpoint: While we are not currently in recession, the economy is operating on a knife’s edge and is vulnerable to slipping into recession if conditions deteriorate.
The Sahm Rule
There have been two quarters of slower growth relative to the previous quarter. So yes, economic growth has slowed in recent months. But that’s not to say that growth has ended or that the Fed’s tightening has affected the labor market. The unemployment rate in July dropped to 3.5%, its lowest rate since 1969, which was the height of U.S. industrialization.
The Sahm Rule Recession Indicator remains negative and sufficiently below its 0.5 delimiter, which suggests that a recession is not present.
According to the index—constructed by Claudia Sahm while at the St. Louis Fed—an economy enters a recession when the three-month average of the unemployment rate has moved above its lowest reading of the past 12 months. That has yet to occur.
The unemployment rate
The recovery from the pandemic has been remarkably quick, with the unemployment rate falling below what is considered to be a non-inflationary level.
The latest estimate of the natural rate of unemployment from the nonpartisan Congressional Budget Office is 4.4%. That is, at any time, 4.4% of the labor force is changing jobs for any number of reasons, ranging from layoffs to employees voluntarily seeking new jobs.
With the unemployment rate at 3.5%, the Fed would have had the leeway to begin normalizing interest rates even if external shocks had not exacerbated the recent increases in inflation.
The labor market has reached a milestone with a general return to pre-pandemic levels of employment. As of July, 152.5 million people were on the payrolls of private employers, surpassing the February 2020 level by 0.02%. Government employment remains 2.6% lower, with local governments yet to fill pre-pandemic ranks.
In the goods-producing sector, construction employment had returned to pre-pandemic levels by February and manufacturing had done so by June, while mining employment still shows a deficit.
And in the service sector, employment levels in trade and transportation, and in professional and business services, now surpass the levels of February 2020, while employment deficits remain in leisure and hospitality and in local government.
Reaching that milestone is encouraging, but that puts us back only to square one. There is still work to be done to recover the lost output over the past two and a half years, and for the labor market to accommodate population growth.
The Fed has a dual mandate: to promote full employment and price stability. Inflation over the past decade has not been a problem, flirting instead with deflation as Americans were able to purchase an abundance of goods at cheap prices.
In particular, the price of gasoline responded to an oil glut in the middle of the last decade’s business cycle and then to a plunge in demand during the pandemic.
The multiple shocks of the health crisis, supply chain issues and geopolitical strife, however, have created the conditions for persistent inflation.
The public and the markets appear to have confidence in the Fed’s ability to contain inflation over the long term. Surveys of consumers show a moderation of inflation expectations to 5% in the next year, before returning to 3%—the top of the Fed’s post-pandemic target range—over the next five to 10 years. That’s not a spectacular improvement, but at least it’s not an expectation of runaway inflation.
The forward markets imply a return to 2.7% inflation in 10 years. Again, nothing to write home about.
Inflation expectations would be expected to increase along with economic growth as the recovery took hold after the health crisis. A year ago, inflation expectations were benign, barely above the Fed’s 2% target. The spike in oil prices, however, raised model-based expectations for inflation published by the Philadelphia Fed. But still, there was little sign of runaway inflation in the near or the long term.
Nonresidential investment consists of purchases of structures, equipment and software. You would expect investment to decelerate as the business cycle winds down, which is what occurred leading into the early-1990s recession, the 2001 recession and the 2008-09 Great Recession.
But this time around, growing investment in productivity and competitiveness has the potential for increasing GDP.
For the middle market specifically, this is supported by recent RSM US Middle Market Business Index data on expectations for increasing capital expenditures. In that survey of senior executives at middle market businesses, more than half said they intend to increase capital expenditures over the next six months, a level that has been unchanged this year.
Investment in research and development and other intellectual property contributes to innovation and U.S. economic growth. Beginning in the third quarter of 2020, there have been eight consecutive quarters of growth in investment in intellectual property. If there is a future in the U.S. production sector, given the difficulty in staffing, then it probably resides in advanced manufacturing.
The production sector
Year-over-year industrial production growth averaged 4.6% over the first seven months of this year, dropping to 3.9% in July. In the months after a recession, we would expect a rapid acceleration in growth compared to the low levels of the downturn, and then diminishing yearly growth rates in subsequent months.
Still, those growth rates are quite high compared to the average 2.6% growth during non-recession months from 1992 to 2019, and it remains to be seen how long the rebound in industrial production can be sustained. (Real GDP has already dropped to a 1.6% yearly growth rate in the second quarter, about what we would expect until the infrastructure programs kick in.) While the investment in research and development suggests continued growth, geopolitical trauma might continue to interfere.
Manufacturing and trade inventories grew at a 16% yearly rate in the first six months of the year, compared to a 3.6% non-recessionary average from 1992 to 2019.
If there was overstocking caused by delayed deliveries, we would expect a negative impact on GDP in the coming quarters as manufacturers reduce supplies and as wholesalers and retailers sell their surplus at lower prices.
Or if there are lessons to be learned from the pandemic, then once-shy businesses might continue to buy too much. Regardless, there are bound to be further distortions to GDP caused by supply-chain timing issues.
Supply chain repair
The supply chain has been making progress over the past nine months after bottoming out last October. That is according to the RSM US Supply Chain Index, which is a composite measure of logistics and manpower moving goods from one place to another.
Some of that progress is the result of playing catch-up to the surge in demand immediately after the worst of the pandemic and to the respite given by the more recent shutdown in China’s production. Still, the seaports in Southern California are capable of handling record numbers of containers and more shipping has been distributed to ports on the East Coast.
There are still issues to be sorted out regarding working conditions for truckers, but employment in transportation and material moving occupations has increased from 6.4% of total employment at the end of 2019 to 7.5% in July this year.
U.S. financial conditions have improved along with the equity markets but continue to imply an increased level of risk. That increased risk results in a higher cost of investment and a lower propensity to borrow or to lend.
Since hitting bottom on June 17, the equity market has recovered 50% of its lost ground. Whether that is the product of confidence in monetary policy and a sign of another bull market remains to be seen.
But there have been moments when the stock market and the bond market have moved in the same direction—just a summer fling perhaps in a sector more driven by speculation than other assets.
As such, the money markets have managed to adjust to the rapid increase in overnight rates and have remained in neutral conditions. The bond market suffers from elevated levels of volatility, with Fed rate hikes pressuring the front end of the curve higher, all while concerns about next year’s growth pressure 10-year yields below 3% once again.
The outlook for risk
The increased risk being priced into financial assets can be seen in the decelerating trend in corporate issuance, which peaked at the end of last year and into the first quarter of this year. This moderation in issuance coincided with growing awareness of the shift in monetary policy as rising inflation forced the Fed’s hand, and as the consensus turned to slower growth in the coming quarters.
What could derail the economy?
Typically, economic growth begins to wane as the business cycle matures. But it usually takes an event to push it over the edge into recession.
The late-1980s slowdown in government spending and waning investment followed by yet another oil shock became the early 1990s recession. The dot.com bust, followed by the Sept. 11 attack, was responsible for the 2001 recession. The mortgage crisis culminating in the collapse of Lehman Brothers created the Great Recession of 2008-09. The U.S. trade war followed by the health crisis created the 2020 recession.
What are the tripwires for the next recession? The most obvious candidate is the collapse of cryptocurrencies if losses resume and reduce confidence in the stability of the financial markets or cause a fire sale of other assets.
But the more likely catalysts for a recession are the continuance of Russia’s war on Ukraine—and its effect on energy, food and rare mineral prices—and a debt crisis or health crisis in China. There would undoubtedly be spillover effects into developing economies as well as Western economies.
The effects would be higher energy and food prices that would drain additional resources away from American household balance sheets, reducing consumer spending, the principal component of U.S. GDP growth.
Real disposable income, which is inflation-adjusted income excluding transfer payments, has been dropping as inflation has been rising. This occurred first as inflation increased along with the economic recovery and again as the energy crisis intensified because of the war in Ukraine.