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Is a recession coming soon?

  • We think that the economy is well-placed to handle higher interest rates and anticipate a period of weak economic growth rather than an outright recession: Rate-sensitive spending is a relatively small share of the economy right now, there are no egregious balance sheet vulnerabilities, and the extended period of shortages means that pent-up demand could keep the economy afloat for at least the next 12 months. Finally, a drop back in commodity prices should provide a modest boost to real incomes.
  • Admittedly, GDP contracted in the first quarter and a further decline in the second is possible, which would meet the two consecutive quarters of negative growth threshold used to define recessions in other countries. Our own estimate still points to a modest 1.1% annualised gain in the second quarter, but the Atlanta Fed’s nowcast points to a 1.2% decline. If the US economy is already in recession, however, it’s the strangest one we’ve ever experienced. The latest monthly employment and activity data paint a significantly more upbeat picture. The coincident indicators used by the NBER to mark turning points in the US business cycle (non-farm payroll employment, retail sales, industrial production and real incomes excluding transfers) have all been increasing at a rapid clip in recent months. None of them are anywhere near recessionary territory.
  • Unlike the mid-2000s, household balance sheets are currently in good shape – debt is much lower relative to incomes, the average credit quality of that debt is higher and, even allowing for the most recent slump in stock markets, household net worth will remain significantly above its pre-pandemic level. Higher interest rates will raise the household debt servicing cost from 9% of disposable incomes to 11%, but we suspect households can cope with such an increase, in part by reducing their saving rate further.
  • Some parts of the economy are inherently more sensitive to rising interest rates that others, with residential investment, durables consumption and business equipment investment the most susceptible. Despite the extended period of very low interest rates over the last decade, however, and the return to near-zero rates during the pandemic, the economy has not become overly dependent on rate-sensitive spending.
  • Furthermore, pent-up demand caused by the acute supply shortages that built up during the pandemic should now support both consumption and investment over the next 12 months, particularly in those sectors like motor vehicles and housing that are usually the most sensitive to higher interest rates. In addition, despite reports that some specific retailers have found themselves saddled with too much inventory, the aggregate data show that inventories are still unusually lean, indicating that there is scope for a further rebuilding. Finally, in stark contrast to the first half of this year when prices surged, we expect the drop back in commodity prices, which has now begun in earnest, to boost real incomes again.
  • With inflation running at more than 8%, there is a misconception that the Fed will necessarily have to engineer a recession to successfully bring inflation back down to the 2% target. When an economy is on the vertical part of the supply curve, however, small changes in output can generate not just big inflation increases, but big declines too. The upshot is that, together with an improvement in supply, only a slight moderation in demand may be needed to generate the required drop back in price inflation.

Is a recession coming soon?

The Fed has embarked on what will be the biggest and most rapid monetary tightening in more than thirty years. That has inevitably led to speculation that, like it did in the early 1980s under then Chair Paul Volcker, the Fed’s efforts to rein in inflation will plunge the economy into recession. Markets look rattled, with the yield curve partially inverting and the S&P 500 in a full-blown bear market. The usual suspects are declaring that a recession is inevitable (see here and here) and, according to the latest WSJ poll, even mainstream economists think the odds of a recession could be close to 50% (here).

Prompted by a sell-off in equities in late summer 2011, the same characters were also convinced that a “double-dip” recession was inevitable in 2012, however. (See here and here.) And at that time even mainstream economists put the odds of a downturn as high as 30% (here). Yet GDP ended up growing by 1.5% in 2011 and 1.6% in 2012, as those recession fears proved to be badly misplaced. As we argue in this Focus, we expect a broadly similar outcome this time too.

Is the US already in recession?

Admittedly, the 1.6% annualised decline in first-quarter GDP suggests the economy was already teetering on the edge and, with the Atlanta Fed’s GDP Now currently pointing to a 1.2% annualised decline in second-quarter GDP growth, that would meet the two quarters of negative growth used to define a recession in other countries. (See Chart 1.)

Chart 1: Contributions to Q2 GDP Growth (% Pts)

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Sources: Atlanta Fed, Capital Economics

We still have second-quarter GDP growth tracking at 1.1% annualised, however, with a stronger contribution from net trade and less of a drag from slower inventory accumulation. Nevertheless, even our second-quarter estimate has been falling sharply in recent weeks, particularly after the final revision to first-quarter GDP, which incorporated a big downward revision to services consumption and upward revision to inventories.

If the US economy is already in recession, however, it’s the strangest one we’ve ever experienced. The latest monthly employment and activity data paint a significantly more upbeat picture. The coincident indicators used by the NBER to mark turning points in the US business cycle (non-farm payroll employment, retail sales, industrial production and real incomes excluding transfers) have all been increasing at a rapid clip in recent months. (See Chart 2.) None of them are anywhere near recessionary territory.

Chart 2: Coincident Indicators (Feb. 2020 = 100)

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Source: Refinitiv

Non-farm payroll employment increased at a ridiculously strong average monthly pace of 457,000 over the first six months of this year and the unemployment rate continued to edge lower. Employment is sometimes dismissed as a lagging indicator, but it is part of the coincident indicators index for good reason.

To put the current discrepancy in GDP and employment into perspective, if the Atlanta Fed’s GDP estimate turns out to be correct and the employment figures remained unrevised, that would imply a near-3% decline in productivity over the first half of this year, which would reverse all the gains over the preceding two years.

Admittedly, employment growth might be revised lower eventually, but the currently estimated growth is so strong that there is close to zero chance of those gains being revised all the way to declines. It’s also possible that the GDP data could be revised up instead, however, with the annual revisions due to be incorporated when the preliminary second-quarter estimate is released at the end of this month. (In recent quarters, the gross domestic income figures suggest the economy was growing much more rapidly than the GDP figures imply.)

Chart 3: ISM Composite Activty Index & GDP

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Source: Refinitiv

Some of the survey data have weakened in recent months, with the ISM composite PMI now at a level consistent with GDP growth of around 2%. (See Chart 3.) But it is still some way off pointing to an outright recession. Similarly, while initial jobless claims have ticked up from below 200,000 to 230,000, that rise is consistent with slightly slower GDP growth rather than a more serious downturn. Finally, the slump in the University of Michigan's measure of consumer confidence leaves it at a recessionary level, but the much more modest decline in the alternative Conference Board measure is consistent with nothing worse that slightly slower GDP growth.

Chart 4: Probability of Recession 6m Ahead

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Source: Refinitiv

Our composite recession tracker still points to a relatively low probability of recession over the next six months. (See Chart 4.)

In summary, despite the weakness of GDP in the first half of this year, we think it is unlikely that the economy is currently in recession. With the Fed hiking interest rates very aggressively, however, the risk is that the current slowdown in GDP growth will eventually develop into a full-blown recession.

Is the US headed for a recession?

The surge in long-term borrowing costs since late last year is the biggest cumulative increase since the mid-1990s. (See Chart 5.) Nevertheless, both households and businesses appear to be well-placed to cope with higher rates: rate-sensitive spending is a relatively small share of the economy right now, there are no egregious balance sheet vulnerabilities, and the extended period of shortages means that pent-up demand could keep the economy afloat for at least the next 12 months. Finally, a drop back in commodity prices should provide a modest boost to real incomes.

Chart 5: Long-Term Interest Rates (%)

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Source: Refinitiv

Household balance sheets in good shape

Unlike the mid-2000s, household balance sheets are currently in good shape, with debt relatively low when compared with incomes. (See Chart 6.)

Chart 6: Household Debt & Net Worth (% of GDP)

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Source: Refinitiv

Furthermore, even allowing for the further steep declines in equity values during the second quarter, household net worth will also remain significantly above its pre-pandemic level. It’s true that households have been eating into their savings over the first half of the year, as they try to cope with rapidly rising prices for necessities but, at 5.5%, there is still scope for the saving rate to go even lower if needed.

With debt relatively constrained, the surge in borrowing costs should be manageable. If the 30-year fixed mortgage rate remained at 6%, our model suggests that households’ debt servicing costs will rise from 9.3% of disposable income to around 11%. (See Chart 7.) Most of that rise could be absorbed by a further reduction in the saving rate.

Chart 7: Household Debt Servicing (As % of Income)

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Source: Refinitiv

Not only is household debt lower than at the time the housing bubble burst in 2007, but the quality of that debt is significantly higher. Sub-prime loans account for a smaller share of both auto loans and mortgages. (See Chart 8.)

Chart 8: Sub-Prime Loans (As % of Total)

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Source: Refinitiv

The higher quality of household debt helps to explain why the serious delinquency rate was at a record low in the first quarter. Admittedly, that is partly because of the moratorium on student loan repayments, but the delinquency rates for auto loans and mortgages are also unusually low. Obviously, if the economy fell into recession and the unemployment rate increased, we would anticipate a pick-up in loan delinquencies and defaults too. But from such a low starting point, the increase should be manageable for financial institutions.

We do expect a 5% peak-to-trough decline in house prices, but that wouldn’t push many borrowers into negative equity given the 38% rise in prices over the past two years, particularly not when loan-to-value ratios are, on average, lower than they were during the housing bubble.

The corporate debt-to-GDP ratio still looks elevated, but that is not a very good yardstick with which to measure the ability of businesses to weather rising interest rates, because there has been a structural increase in the corporate profit share of GDP. Measured against corporate internal funds (profits after taxes and dividends), corporate debt appears well within the historical range. (See Chart 9.)

Chart 9: Non-Financial Corporate Debt Ratios

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Source: Refinitiv

Overall, private sector balance sheets appear to be in good health, suggesting that households and businesses are well-placed to cope with higher interest rates.

Rate-sensitive spending muted

Some parts of the economy are inherently more sensitive to rising interest rates that others, with residential investment, durables consumption and business equipment investment most susceptible. Despite the extended period of very low interest rates over the last decade, however, the economy has not become overly dependent on rate-sensitive spending, which bodes well now that rates have rebounded. (See Chart 10.) Admittedly, the combined share of spending did increase during the pandemic, from 16.5% to 19% of GDP now. But that still leaves it well below the average over the past 50 years and, except for the series of rate hikes that began in late-2015, lower than at the start of every Fed tightening cycle.

Chart 10: Rate-Sensitive Expenditure (As % of GDP)

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Source: Refinitiv

As a share of GDP, residential investment is still only back to its long-run average – after spending close to a decade below that average. Business equipment investment is also below its average and, despite near-zero interest rates, that share fell during the pandemic. Durables consumption looks a little elevated as a share of GDP, partly reflecting the fiscal stimulus payments and the rotation to goods spending when pandemic restrictions reduced high-contact services spending. (See Chart 11.)

Chart 11: Rate-Sensitive Expenditure (As % of GDP)

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Source: Refinitiv

Furthermore, arguably the biggest issue is that shortages of machinery, electrical equipment and, particularly motor vehicles and trucks, have been holding back business investment and durables consumption. Approaching two years after their launch, it is still very difficult to buy the latest generation video game consoles. As semiconductor shortages ease, pent up demand should support spending on those supply-constrained goods, even in a higher interest rate environment.

Pent-up demand should support spending

With motor vehicle sales currently running at only 13 million annualised, they are already at recessionary levels, suggesting there is little scope for sales to fall any further. (See Chart 12.) The problem is supply rather than weak demand. Ford stopped taking orders for its best-selling 2022 F 150 pick-up truck in mid-May, even though production of this year’s model will continue for another few months. Order wait times for vehicles from Asian manufacturers are even longer because of supply chain disruptions caused by China’s zero-covid policy and shipping delays. Wait times for most EVs are six to 12 months.

Chart 12: Light Vehicle Sales (Mn, Annualised)

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Source: Refinitiv

As semiconductor shortages gradually ease – in part because the collapse in cryptocurrency prices will reduce demand for computers used to mine those currencies – we would expect vehicle sales to increase from the current low level as pre-orders are finally delivered, even though higher rates may otherwise weaken demand.

Chart 13: Housing Starts & Under Construction (Mn)

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Source: Refinitiv

Backlogs in the construction industry caused by labour shortages and high materials prices/ shortages imply there is plenty of pent-up demand, which means the decline in housing activity could also be more modest than the surge in mortgage rates would otherwise imply. As Chart 13 shows, although housing starts have remained well below the 2006 peak, houses under construction are currently at a record high.

Furthermore, the number of building permits issued where construction has not yet started is also at a record high. (See Chart 14.)

Chart 14: Building Permit Issued But Construction Not Started (000s)

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Source: Refinitiv

The upshot is that pent-up demand caused by the acute supply shortages that built up during the pandemic should now support both consumption and investment over the next 12 months, particularly in those sectors like motor vehicles and housing that are usually the most sensitive to higher interest rates.

Inventory rebuilding has further to run

Finally, despite reports that some specific retailers have found themselves saddled with too much inventory, the aggregate data show that inventories are still unusually lean, indicating that there is still scope for a further rebuilding. (See Chart 15.)

Chart 15: Retail Inventory-to-Sales Ratio

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Source: Refinitiv

Is a recession necessary to get inflation down?

With inflation running at more than 8%, there is a misconception that the Fed will necessarily have to engineer a recession to successfully bring inflation back down to the 2% target. When an economy is on the vertical part of the supply curve, however, small changes in output can generate not just big inflation increases, but big inflation declines too. The upshot is that, together with an improvement in supply, only a slight moderation in demand may be needed to generate the required drop back in price inflation.

The experience of the past few years has lent more support to the idea that the aggregate supply curve is shaped like a hockey stick. When output is below its potential, the supply curve is essentially flat, with shifts in demand generating potentially big changes in output but only small changes in prices. This is the pre-pandemic world we lived in for the past couple of decades. A shift in demand from AD1 to AD2 generates only a modest increase in the price level from P0 to P1 when the economy is operating on the AS1 supply curve. (See Chart 16.)

Chart 16: Aggregate Demand & Supply

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Source: CE

As output moves above the economy’s long-run potential, however, the supply curve becomes vertical, meaning that relatively modest changes in output will generate big changes in prices.

There were two key changes during the pandemic: A shift right in the demand curve from AD1 to AD2, in part due to the boost from fiscal stimulus and looser monetary policy, which coincided with the easing of lockdowns. At the same time, the labour force exodus triggered by the surge in retirements and the ongoing problems with global supply chains – as covid outbreaks constrained production in other countries – triggered a shift left in the supply curve from AS1 to AS2. The upshot is that the economy quickly moved from the flat part of the supply curve (where big moves in output generate only small moves in prices) to the vertical part (where small moves in output generate big moves in prices).

The recent experience in the used vehicle market is a good illustration of the non-linear response in prices when supply becomes constrained. Between 2014 and 2019, real consumption increased at a solid clip, rising by close to 100% cumulatively, yet prices continued to fall during that period. Skip forward to the pandemic period, however, and a further modest rise in real consumption triggered a massive ~50% surge in prices. (See Chart 17.) That non-linear surge in prices happened because the supply of used vehicle coming onto the market was reduced because sales of new vehicles fell, meaning that there were fewer trade-ins coming onto the market.

Chart 17: Used Vehicles Price & Consumption

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Source: Refinitiv

When discussing what will be required to bring inflation back down to the 2% target, commentators make two common mistakes. First, that the economy is on the flat part of the aggregate supply curve and, second, that all the adjustment needs to come via a shift in demand. The upshot of those two assumptions is that those commentators then conclude that it will require a substantial weakening of demand / sustained rise in unemployment to bring inflation down. In short, a recession becomes all but inevitable.

In contrast, we would stress that when the economy is on the vertical part of the supply curve – where small changes in output generate big changes in prices – so even a modest drop in demand should trigger a significant drop back in price inflation. Prices for some goods like used vehicles will even fall outright, partially reversing the massive run up in prices over the preceding two years. We are already seeing this phenomenon play out with many commodity prices. Industrial metals, agriculturals, lumber and even energy prices have fallen back significantly from their peaks, as investors anticipate slower global economic growth. The spike in sea and land shipping costs last year, which more recently has been partially reversed, is another illustration of how big price moves can be when output is close to capacity – not just on the way up but on the way down too.

Moreover, rather than relying solely on shifts in demand, some of the required easing in price pressures can be achieved via a shift back in the supply curve too: as the labour participation rate continues to rebound and as global supply chain problems gradually ease. As the economy shifts back to AS1, from AS2, it would return to the flat part of the supply curve even if demand was unchanged – i.e. it remained at AD2.

In theory, inflation could remain high if inflation expectations became unanchored and a genuine wage/price spiral developed. But, while our common inflation expectations index has risen and is currently close to a 20-year high, the bottom line is that medium-term expectations for CPI inflation are still only 2.5%, even when actual CPI inflation has surged above 8%. (See Chart 18.) That suggests to us that inflation expectations have remained surprisingly well anchored.

Chart 18: CE Common Inflation Expectations (%)

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Source: CE Interactive

The upshot is that this pandemic-related episode of high inflation appears to have more in common with the temporary surges in inflation in the aftermaths of the civil war and the two world wars, rather than the more sustained pick-up in inflation in the 1970s. (See Chart 19.) In each episode supply was disrupted and couldn’t keep up with demand – as it took time to reconfigure production from military to civilian uses, while demand for those civilian goods quickly rebounded.

Chart 19: CPI Inflation (%)

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Source: NBER, Refinitiv

As others have pointed out (see here), there are plenty of key differences between now and the 1970s stagflation, when inflation remained high even as unemployment surged, suggesting that a sustained wage-price spiral in unlikely. Note that there were accompanying spikes in wage inflation after both world wars too, but they did not generate lasting wage-price spirals.

Chart 20: Average Earnings (%y/y)

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Source: NBER, Refinitiv

Accordingly, there is still a good chance that, as supply improves, inflation will fall back markedly, without the need for a massive decline in demand or a significant rise in the unemployment rate. Over the three-to-five-year time horizon, if supply over-corrects deflation might even be the bigger risk.

Conclusions

We think that the economy is well-placed to handle higher interest rates and anticipate a period of weak economic growth rather than an outright recession: Rate-sensitive spending is a relatively small share of the economy right now, there are no egregious balance sheet imbalances, and the extended period of shortages means that pent-up demand could keep the economy afloat for at least the next 12 months. Finally, a drop back in commodity prices should provide a modest boost to real incomes.


Paul Ashworth, Chief US Economist, paul.ashworth@capitaleconomics.com