Over the past few months, investors have battled over the likelihood of a recession, defined as two consecutive quarters of negative GDP growth. Some assert that a recession is inevitable, while others argue that the US could instead achieve a soft landing through which a recession is avoided and inflation is tamed. Nevertheless, the economy is in a tricky place and there is no correct economic outlook for next year. According to the New York Federal Reserve, the odds of a recession in the next 12 months have decreased from last quarter’s forecast of 69% to 56%. However, the situation could still swing either way.
The concerns over a recession have emerged primarily due to inflation. The US witnessed its highest inflation since the start of the 21st century, reaching a peak of 9.1% in June 2022, as measured by the Consumer Price Index (CPI). Although the current inflation rate has declined to a level of 3.7%, it has yet to return to the Federal Reserve’s 2% target. The Federal Open Market Committee (FOMC), a branch of the Federal Reserve, has since announced 11 interest rate hikes, starting in March 2022, that sought to combat inflation. Interest rates play a role in reducing inflation by increasing the cost of borrowing, thereby decreasing demand, increasing supply, and lowering prices. The latest rate hike in July 2023 brought the rate to 5.50%, the highest in 22 years. The Fed has since decided to pause rate hikes. While this suggests that the Fed has been able to decrease inflation, many believe that the rapid rate hikes have yet to reveal their full impact on the US economy and could potentially push the US into a recession.
As previously mentioned, a high interest rate environment suppresses inflation but leads to less demand and thus, slower economic growth. This can lead to a decline in a country’s GDP, potentially causing a recession. For instance, interest rate pressures in Europe have caused the eurozone’s GDP to contract 0.1% in the third quarter and is predicted to fall yet again in the fourth quarter. On the other hand, the United States, contrary to expectations, is undergoing robust GDP growth, evident in the 4.9% increase in the third quarter. According to Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management, “GDP growth keeps surprising us regardless of mixed signals from other economic measures.” This unexpected growth has compelled experts to revise their initial estimates of when a recession might occur.
The economy’s summer growth could be a result of cooling inflation and wage increases. Ian Shepherdson, chief economist at Pantheon Macroeconomics, estimates that inflation-adjusted incomes after taxes rose at an annualized rate of 7%. The rise in income pushed the household savings rate to 5.3% in May from 3.4% last December. This signifies increased purchasing power for consumers, potentially leading to higher inflation. The improved economic growth may also be a result of reduced supply shortages and bottlenecks, positively impacting economic development. However, there is a possibility that the recent GDP growth may be short-lived. But if it persists, the economy could face inflationary pressures as increased GDP growth generally implies increased demand and, therefore, increased prices. This could potentially prompt the Federal Reserve to implement another rate hike, a move that would likely push the United States into a recession. Federal Reserve Chair Jerome Powell has indicated a willingness to consider another rate hike if inflation pressures escalate.
Furthermore, examining unemployment rates and wage levels is crucial for understanding the current economic landscape. As of October, the United States has experienced a rise in its unemployment rate, reaching 3.9% and surpassing the 3.4% rate observed in April. This increase could signal economic recession tendencies, given that higher unemployment typically correlates with reduced economic activity. The uptick in unemployment, however, has helped in decreasing inflation. Striking the right balance to decrease inflation without pushing the economy into a recession becomes a critical challenge. On a positive note, September saw the addition of 336,000 jobs, a promising sign that the US is able to keep unemployment rates in check despite inflation and high interest rates. In terms of wages, the US average hourly earnings is at $34.00, 4.1% up from last year. While this may suggest enhanced purchasing power, it could be counterbalanced by a potential reduction in working hours. Furthermore, year-over-year weekly wages in September declined 0.2%. This indicates a potential pullback in household spending which represents another recession risk.
Despite the decrease in inflation, the growth in GDP and the recent surge in job additions indicate that the Federal Reserve’s interest rate hikes have not yet exerted their intended cooling effect to the fullest extent. According to Powell, this could be a result of the fact that many individuals and businesses locked in on low-interest rate loans during the pandemic. What this means is that, with higher interest rates, people are disinclined to take out loans and mortgages, instead locking in on their previous rates established when the Fed’s short-term rate target was near zero. However, there is a looming concern among investors that the swift rate hikes could eventually impact the economy significantly, potentially pushing the US into a recession as economic activity diminishes. This is an entirely possible scenario considering the high-interest rate environment will likely stay elevated for the foreseeable future until inflation achieves the Fed’s 2% target.
Given the current circumstances, the Federal Reserve finds itself in a position where the most prudent course of action is to observe and assess the economy’s reaction to interest rates, gauging whether it might precipitate a recession. Recently, the US economy has experienced a rise in GDP growth as a result of cooling inflation and greater purchasing power amongst consumers. While sustained GDP growth implies heightened inflationary pressures, potentially prompting the Fed to implement another rate hike that could, in turn, lead to a recession, it also suggests the overall resilience of the U.S. economy in coping with elevated rates. The recent uptick in unemployment, which typically contributes to lowering inflation, could signal recessionary risks if not managed effectively. However, the September jobs report presents an alternative scenario, hinting at the potential for a soft landing. Consequently, the economy currently exists in a nebulous state, making it challenging to predict a recession definitively, as there are compelling indicators on both sides of the debate.
Regardless of whether a recession comes or not, the Federal Reserve will consistently monitor economic indicators such as consumer purchasing power, influenced by job and wage growth, as well as inflation, affected by interest rates, among other factors. Looking at these key metrics will enable the US to decide the next steps in avoiding a recession.
