Can America Really Avoid a Recession?

After a year in which two consecutive quarters of negative GDP growth fueled the greatest fears of a recession, the US has now recorded three consecutive quarters of positive real growth.

Written by: JOSEPH POLITANO

Compile: Block unicorn

With real growth, although positive, weak and inflation slowly decelerating, can the US really avoid a recession?

Since the Federal Reserve System started raising interest rates in early 2022, the U.S. economy has slowed significantly—real growth has declined, driven largely by a decline in fixed investment, and nominal spending growth has also fallen sharply. However, we are far from an official recession being declared - of the six indicators that the National Bureau of Economic Research's Recession Date Committee looks at before declaring an official recession, only two (industrial production and real retail-wholesale sales) are still below its previous peak levels. Meanwhile, inflation and nominal growth have been trending downwards for several months. That's part of the reason Federal Reserve officials have shown a glimmer of optimism despite strained financial conditions following the recent banking crisis. The Federal Reserve no longer thinks "some additional policy tightening is needed," although it still leaves room to potentially raise rates further if economic data is strong. Jerome Powell said, "It seems to me that a recession is more likely to be avoided than to occur," in contrast to the Federal Reserve's recent forecasts, which see unemployment rising to Rising rapidly, entering a recession state.

However, the economy remains too strong for the Federal Reserve System's liking—the justification for pausing raising interest rates relies on the "cumulative tightening of monetary policy" and the "lag effects of monetary policy on economic activity and inflation" being sufficient to further depress nominal growth and future inflation. Nor can this cumulative contraction be enough to push the U.S. economy into recession - since 2022 real growth has been weak despite being positive. Over the past year, nominal gross domestic product (NGDP, the dollar size of the U.S. economy) has grown by nearly 7%, but only 1.6% when adjusted for inflation.

However, growth in nominal gross domestic product (NGDP) has slowed significantly in 2022, reaching its slowest pace in the first quarter of this year since the start of the pandemic. It's still too high to be reassuring -- 5% annualized, compared to about 4% that's consistent with 2% inflation and close to pre-pandemic norms, and items like consumption growth are still bigger than that. Overall growth is higher, but it has made significant progress toward target levels without job losses or the onset of a recession.

Growth in gross labor income (GLI, the total earnings of all workers in the economy) also continued to decelerate, approaching pre-pandemic norms. Both robust real-time measures derived from the Employment Cost Index and household employment levels, as well as more frequent non-farm payroll data, point to GLI growth of only 6.2% and 6.6% over the past year (compared to , the norm before the new crown epidemic was about 5%). For the Federal Reserve System, which is now primarily concerned about the impact of inflation on core services, the normalization of GLI growth should be a welcome harbinger of a deceleration in the prices of house prices and labor-intensive nonhousing services.

Overall, we still see some deceleration in cyclical nominal growth that is necessary to return to the inflation target - but not all that is needed has been achieved, and if the underlying economic data continues to be strong, the Federal Reserve It will take longer than previously expected to achieve its goals. Again, however, a longer and more stable cooldown may have minimized the chances of the kind of rapid economic collapse that has been most feared since the Federal Reserve System began tightening policy last year. So far, the economy has proven more resilient to rising interest rates than previously expected - extending the timetable for repairing inflation while reducing the chances of a recession, though still high.

True Power in America

After a year in which two consecutive quarters of negative GDP growth fueled the greatest fears of a recession, the U.S. has now posted three consecutive quarters of positive real growth. The low but positive figures for the first quarter were stronger than they first appeared - consumption, government spending and net exports all contributed to overall growth, with the main drag being a sharp drop in investment. However, real fixed investment (such as housing construction, factory construction, R&D, etc.) declined only slightly, and the main driver of the weakness in investment was a deceleration in the growth of volatile business inventories.

Indeed, actual final sales to private domestic buyers, a niche measure of growth in private sector consumption and fixed investment, picked up in the first quarter after showing little growth in the past three quarters. Given the importance of this indicator as a proxy for core economic growth -- outside of recessions, it rarely turns negative for a quarter -- it's another sign that the underlying U.S. economy hasn't started contracting yet.

Much of the recent pick-up has been driven by a recovery in real consumption, even if nominal consumption is slowing - reflecting in part improvements in supply and production chains. About one-sixth of the increase in consumer spending in the quarter reflected higher spending on vehicles and parts amid continued improvement in the auto supply chain. Annual real consumption growth rebounding from 2021 lows contrasts sharply with the continued decline in real fixed investment.

While residential fixed investment has now fallen to a seven-year low, it appears to be finally stabilizing as mortgage rates stabilize. Since October, single-family housing starts have remained near the 840k annual level, and multi-family housing starts have remained near the 540k annual level. Nonresidential fixed investment has slowed, but not declined, thanks to relatively strong manufacturing investment following the Chip Act and the Inflation Reduction Act, and still strong intellectual property and R&D spending.

In reality, actual fixed investment may be stronger than current data suggest—when projects do not report monthly values constructed, the Census Bureau estimates nominal construction expenditures based on the project's original 101.5% of estimated cost, then unresponsive items are complete. Given the persistently high inflation rate for construction materials, projects have consistently exceeded initial budgets, causing the Census Bureau's nonresidential spending figures to have been revised upwards after initially unresponsive firms submitted data for previously imputed projects. Federal Reserve System researchers (Brandsaas, Garcia, Nichols, and Sadovi) estimate that the correct value of real nonresidential fixed investment may be 20% higher than currently reported, based on simple forecasting models for other real nonresidential spending data. So, during the latest period of inflation, fixed investment could be revised sharply higher - which would further strengthen recent economic data.

NOMINAL GROWTH, LABOR MARKET AND INFLATION

However, further reductions in total labor income growth will still be required to bring inflation back to target. Despite massive pandemic-era stimulus and a shift in borrowing behavior, as Matt Klein has repeatedly emphasized, nominal consumer spending and aggregate wages have largely grown in tandem from early 2021 onwards. Unsustainably high consumption growth is part of the rapid growth in household income, which still needs to decelerate to bring inflation back to the Fed's 2% trend.

However, the labor market has also cooled sharply over the past year, without entering recessionary territory. Growth in average hourly wages has fallen from 6% to less than 4.5%, and the more robust component adjusted employment cost index has slipped to 5% from 5.7%, while the unemployment rate has not risen.

Leading indicators of labor market strength and total labor income growth have also weakened sharply. The number of workers who are quitting their jobs each month has fallen from a high of 4.5 million a month in early 2022 to 3.9 million a month now, and the number of workers laid off each month has increased to pre-pandemic norms in recent months. Serial jobless claims also remain above late 2022 levels after the recent rebound and closer to the pre-pandemic average.

These all help reduce nominal spending growth from extremely high levels in 2021 and 2022 to more reasonable but still historically high levels. Per capita spending has risen by 6.7% over the past year, and quarterly growth has actually picked up earlier this year compared with the long-term norm of around 4%. Spending growth will need to decelerate further to keep inflation in check.

in conclusion

When the Federal Open Market Committee (FOMC) made its economic forecasts in March, the median participant expected the unemployment rate to reach 4.5% by the end of the year, which was only slightly more optimistic than the December 2022 forecast of 4.6%. As time goes on, those forecasts look less and less realistic - for the unemployment rate to reach 4.5% by the end of the year, it would need to rise by more than 0.1% every month. Assuming a constant workforce size, this would require sustained net job losses averaging around 200-250k per month, a pace only in line with the worst recessions in the US.

Yet the debt market is not pricing in a catastrophic downturn—high-yield corporate bond spreads, a proxy for the risk of default by large corporations, and thus an important recession indicator—despite a downturn in the wake of Silicon Valley Bank and other U.S. regional banks. The rally resulting from the crash is actually still below the 2022 peak.

At the next FOMC meeting, the most likely outcome is that participants will once again be forced to revise their forecasts—both by extending the time frame before they expect to see a contraction in the economy and by minimizing expected shrinkage scale. The preparation time is getting longer and longer, and the landing is expected to be softer and softer.