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Why the Recession Is Always Six Months Away
Continued strong hiring and consumer spending are complicating Federal Reserve Chair Jerome Powell’s campaign to tame inflation.
The next economic downturn has become the most anticipated recession in recent U.S. history. It also keeps getting postponed.
Recent strong hiring and consumer spending are the latest evidence that the pandemic and the unprecedented policy measures that followed are interfering with the Federal Reserve’s campaign to tame inflation.
The government’s stimulus measures left household and business finances in unusually strong shape. Shortages of materials and workers mean companies are still struggling to satisfy demand for rate-sensitive goods, such as homes and autos. And Americans are splurging on labor-intensive activities they avoided in recent years, including dining out, travel and live entertainment.
Wall Street economists began 2023 broadly anticipating a recession by midyear caused by the weight of the Fed’s rapid interest-rate increases. Some still expect that could happen. Many now think it will take longer to cool the economy and will lead the central bank to raise rates to higher-than-expected levels.
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“It’s the ‘Godot’ recession,” said Ray Farris, chief economist at Credit Suisse. Mr. Farris found himself among a small minority of economists last fall who predicted the economy would narrowly skirt a downturn this year. Every six months, economists have predicted a recession six months later, he said. “By the middle of the year, people will still be expecting a recession in six months’ time.”
The Fed has been trying to slow investment, spending and hiring to combat inflation by raising rates, which makes it more expensive to borrow and can push down the price of assets such as stocks and real estate. After holding the benchmark federal-funds rate near zero during and after the pandemic, officials lifted the rate more over the past 12 months than any time since the early 1980s, most recently to between 4.5% and 4.75% last month.
The economy’s recent pickup will delay Fed officials’ deliberations about when to pause rate increases. Investors are instead looking for clues about whether they will raise rates by a quarter-percentage-point, as they did last month, or a half-point, as they did in December, at their next meeting, March 21-22.
Fed Chair Jerome Powell is set to begin two days of congressional testimony Tuesday, where he’ll have an opportunity to explain the central bank’s most likely response to a more resilient economy. In December, most Fed officials expected to lift rates this year to between 5% and 5.5%, and officials have indicated those projections could rise at their next meeting.
The economy remains weird
Three factors illustrate the peculiar nature of today’s economic recovery.
First, Washington’s reaction to the initial shock of Covid-19 in March 2020, including holding interest rates at very low levels and showering the economy with cash, left household, business, and local government finances in unusually strong shape.
Through last June, U.S. households had around $1.7 trillion more in savings accumulated through mid-2021 than if income and spending had grown in line with the prepandemic economy, according to estimates by Fed economists. Even after it is spent, money can still slosh through the economy (one person’s spending is, after all, someone else’s income).
“We are going through the second, third, and fourth-round effects of the initial savings spurred by all these transfer payments during the pandemic,” said Peter Berezin, chief global strategist at BCA Research in Montreal. Rate increases can slow the economy more immediately when expansions are fueled by credit growth, as opposed to incomes and stimulus, the big drivers of the postpandemic recovery.
Businesses were able to lock in lower borrowing costs as interest rates plumbed new lows in 2020 and 2021. Just 8% of junk bonds, or those issued by companies without investment-grade ratings, mature over the next two years, according to Goldman Sachs.
Secondly, shortages of materials and workers have made the rate-sensitive housing and auto markets more resilient to higher interest rates—for now. Home builders are resorting heavily to what’s known as buydowns, where they pay to lower the buyer’s mortgage rate for the first year or two. Many current owners are reluctant to sell because they’d have to give up a much lower rate, a phenomenon that is holding for-sale inventories at historically low levels.
Typically when the Fed raises interest rates, demand for housing and cars fall, leading builders and auto makers to cut production and lay off workers. This time around, companies are still playing catch-up.
Construction employment hasn’t fallen despite a severe slump in home sales. Builders are still completing homes and apartments started before the Fed increased interest rates. Supply-chain disruptions have extended the amount of time it takes to complete construction. In addition, apartment building ramped up sharply after the pandemic, and those take longer to finish.
In the auto sector, brands of popular fuel-efficient cars are benefitting from pent-up demand after shortages of semiconductor chips kept inventories of new cars at very low levels.
That could make the usual rate-induced slowdown in autos and housing more gradual, said Eric Rosengren, who was president of the Federal Reserve Bank of Boston from 2007 until 2021. “It may take higher interest rates or interest rates higher for longer to get supply and demand back in alignment.”
Thirdly, U.S. consumers, throwing off their pandemic caution, have ramped up spending on services that require lots of workers—think dining out and travel—another example of pent-up demand interfering with the typical business and interest-rate cycle.
Those sectors are often among the first to see demand fall, prompting job cuts, when consumers worry about losing theirs. The easiest way for households to reduce their expenses is to stop eating out and taking vacations.
Consumer spending has enjoyed a rebound in recent months thanks to lower gasoline prices and an additional boost in January from bigger Social Security checks, which are indexed to prior-year inflation. Gas prices jumped last spring after Russia’s invasion of Ukraine. They then steadily declined over the second half last year, easing a cash crunch for some households that may have offset higher rates on auto loans, credit cards, and mortgages, said economists at Morgan Stanley in a recent report.
Economists at Goldman Sachs said Sunday the Fed could end up raising rates to just below 6% this year if consumer spending runs at higher-than-anticipated levels. That could extend a string of quarter-point rate increases into September.
Labor market conundrum
The labor market sits at the center of Mr. Powell’s worries about inflation. That’s because steady income growth will sustain consumer spending power and allow companies to keep raising prices.ADVERTISEMENT
In the 2000s, then-Fed Chairman Alan Greenspan called it a conundrum that longer-dated bond yields stubbornly refused to rise as the Fed increased rates. For Mr. Powell, the labor market’s strength represents his version of the conundrum. Recession calls keep getting delayed because companies keep hiring and holding on to workers rather than letting them go.
Employers added 517,000 jobs in January, a big figure that shocked economists who were anticipating a slowdown, and pushed the unemployment rate down to 3.4%, a 53-year low. Revisions to earlier reports also pointed to less weakness than initially thought.