We have made the case for some time that the “R” word that best describes the American real economy is resilience, not recession.
Our preferred recession model now implies a shallow recession occurring early next year.
Despite elevated inflation and interest rates, as well as tightening financial conditions and softening demand for loans, the economy has chugged along, thanks in no small part to strong consumer spending.
Now, with an unemployment rate at an all-time low of 3.4%, it’s hard to imagine that the National Bureau of Economic Research will declare a recession anytime this year unless, of course, events like a default on the nation’s debt dictate otherwise.
In fact, our preferred recession model now implies a shallow recession occurring early next year. We think that this is a function of that robust labor market and roughly $500 billion in excess savings sitting on household balance sheets, which according to the San Francisco Federal Reserve should support spending at solid levels through the end of the year.
We think that there is a 75% probability of an economic downturn over the next 12 months. While that is significant, it also implies that there remains a 25% chance of a soft landing for the economy.
And while a bevy of yield-curve models as well as our preferred metric are pointing to a downturn, right now the unstoppable American labor market and cash on hand inside household pocketbooks are preventing that from happening.
Risks to the outlook
The two most interest-rate sensitive economic ecosystems are real estate and manufacturing.
In real estate, rising mortgage rates have dampened housing starts and intensified an affordability issue for many first-time buyers. That is the one area of the economy that contracted last year and is just starting to recover.
Manufacturing, by contrast, has slowed but has not yet declined into recession. While manufacturing sentiment is aligned with contraction, hard data on industrial production does not imply that. And Boeing experiencing a solid increase in orders and government defense spending rising, there is a fair chance that a manufacturing recession can be avoided.
There have been midcycle manufacturing downturns in previous periods, including the global manufacturing recession resulting from the 2018-20 U.S. trade war that did not lead to a general economic recession.
While manufacturing is an important driver of economic growth, it is not the sole determinant of the business cycle.
When do we expect a recession?
The Treasury yield curve continues to signal a recession, the result of the Fed’s program to re-introduce risk into the financial markets.
A yield-curve model by the Federal Reserve Bank of New York is estimating a 68% probability of a recession in 12 months. The Federal Reserve Bank of Cleveland model is pointing to a deceleration in gross domestic product growth in the second half of this year and a 75% probability of a recession in 12 months.
Monetary policy is transmitted to the economy through financial conditions with a lag of nine to 12 months. Increases in the Fed’s overnight policy rate affect expectations of an economic slowdown, which leads to additional risk priced into securities, a higher cost of credit and the tightening of financial conditions that we have seen over the past year. The reluctance to borrow or lend leads to slower growth.
Because short-term interest rates are directly affected by Federal Reserve policy, and because long-term rates are more affected by expectations of economic fundamentals, the difference between 10-year Treasury bond yields and three-month Treasury bill rates has been shown to be a robust predictor of recessions.
The shape of the yield curve first became a concern last year. The yield curve was flattening as the Fed pushed short-term rates rapidly higher while increases in long-term interest rates were moderated by concerns over economic growth. By the end of the year, short-term rates were higher than long-term bond yields, an abnormal condition.
This inversion has occurred before each of the recessions in the postwar era. As of May 12, three-month T-bill rates were priced at 5.20% while 10-year bonds were yielding 3.45%. The current 175 basis-point difference (on an equivalent basis) screams a recession in the making.
According to the yield-curve model reported by the New York Fed, the narrowing yield-curve spreads of the past year implied only a 4% probability of a recession in April 2023. That has now increased to 68% in April 2024, in line with the severity of the inversion.
According to the model at the Cleveland Fed, the probability of a recession in one year increased from 4% in April 2023 to 75% in April 2024, with the downturn starting in the fourth quarter.
While recessionary risks are rising, it appears that firms continue to hire, households continue to spend and the economy continues to grow. Until hiring rolls over and higher-end consumers—the 40% of households that are responsible for 60% of spending—pull back, the economy will continue to muddle through even as firms reduce fixed business investment.
Is the economy already in a recession?
The quick answer is no. Not when the unemployment rate is 3.4%.
An alternative recession model that we closely follow, the Chauvet-Piger recession probability model based on economic variables, identifies when the economy is in recession. As of March, the model on the St. Louis Fed economic data base estimated a less than 1% probability that the economy was in recession.
The factors that underscore this recession model show why the economy has not yet declined into recession and may escape unscathed.
The Chauvet-Piger model uses four coincident monthly variables to identify recessions:
- Nonfarm payroll employment
- The index of industrial production
- Real manufacturing and trade sales
- Real personal income excluding transfer payments
All of these factors have pointed to a resilient economy for the time being. But that could soon change. Growth in industrial production, for example, has been decelerating for months in response to the increased cost of credit, though it remains resilient.
Job creation
The U.S. economy added 250,000 jobs in March, above the 200,000 average monthly increases during the 2009-20 recovery. This suggests a resilient economy still capable of expanding after a series of serious blows.
Industrial production index
The industrial production index appears to have formed a local peak. There were two similar peaks in the prior business cycle, caused by the commodity-price collapse of 2014-15 and the 2018-20 trade war.
Whether this peak turns out to be a bump in the road or the precursor of a slide into recession is still to be determined. The industrial production index for April released by the Federal Reserve rose by 0.5%, suggesting that the economy still has room to run.
Real manufacturing and trade sales
Real (inflation-adjusted) manufacturing and trade sales would be expected to follow the business cycle and inflation. Sales would increase as the economy regains its feet after a recession and then plateau if inflation were to increase. Real sales plummet as the economy drops off into recession.
In this latest cycle, and after quickly recovering from the health crisis, real sales are moving sideways, buffeted by inflation pressures, supply-chain adjustments and shifts in demand.
Real personal income
Real (inflation-adjusted) personal income continues to grow, but at a slower pace than in earlier business cycles. In the three years since the 2020 health crisis, real personal income has grown at an average rate of 2.3% per year. This comes at the expense of high inflation and despite the rapid increase of income among low-wage workers.
As we show, the yearly growth of real personal income has just reached the bottom of the 2% to 4% range of the 2013-2020 business cycle. That speaks to the steadfast response of the Federal Reserve to the impact of inflation on households and the need to cool an overheated economy.
The takeaway
An unemployment rate at 3.4% should be enough to dispel any notion of an economy already in recession.
Instead, if there is a recession, that downturn may occur sometime between the second half of this year and early next year, with the severity of the downturn limited by the robustness of the labor market and what we expect to be further moderation in inflation.
On the upside, economy is still capable of generating 225,000 jobs each month, and real personal income is increasing as inflation recedes.
That implies more life in the recovery and a soft landing for the economy after a year of the Fed stepping on the brakes.
But that optimism is contingent on the government avoiding a default on its debt and whether the banking system can survive its mismanagement of risk and the bursting of the zero-interest rate lending bubble.
