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Are We Headed Into a Recession?Submitted by Sound Foundation Wealth Advisors on July 18th, 2022
Headlines have been all about the potential for an economic recession in the near term. The most recent recession was in early 2020, at the beginning of the pandemic – and it was the shortest recession on record, lasting just two months.
The downturn was severe, as the economy essentially closed down. So how is it possible that we could be headed into another recession when unemployment is low, jobs are plentiful, and the economy is still growing, even if at a slower rate?
In a word: Inflation. We have been in an inflationary environment for the last two years. Higher inflation resulted from the combination of historical fiscal and monetary stimulus, disrupted supply chains, increased demand, and workers either staying home or switching out jobs for better ones, which put upward pressure on wages. All of this increased prices.
The Federal Reserve controls monetary policy, and the lever that lowers inflation is increasing interest rates. Higher rates mean borrowing money costs more for consumers and businesses alike. The higher cost of capital ultimately slows down key sectors of the economy, such as business growth and the housing market.
For most of 2021, the Fed regarded inflation as a “transitory” problem that would resolve as the recovery progressed and things got back to normal. In keeping with this belief, the Fed did not raise interest rates.
As inflation continued to increase, the Fed revised its positioning and indicated a gradual increase in rates would begin. And then Russia invaded Ukraine. Wildly spiking energy prices and increased food costs related to the invasion have pushed inflation to levels not seen in more than 40 years. As inflation continued to spike, the Federal Reserve indicated it would act aggressively to raise rates much more quickly.
This is where recession comes in. The goal of the Fed is to raise rates just enough to slow the economy – "tapping the brakes." Aggressive interest rate increases have the opposite effect, as both the actual impact of higher rates – and the perception that the economy will slow – lead to businesses and consumers pulling back from spending. That’s what causes the recession to set in.
The most recent inflation reading puts the Consumer Price Index at 9.1% - a 40 -year high, but more importantly, much higher than the consensus estimate of 8.8%. It's the surprise spike that has a meaningful impact on sentiment. Out-of-control inflation puts even more pressure on the Fed to move the rate dial more quickly.
How Do We Know If We’re in a Recession?
Since it’s a measure of the economy, the most popular indicator is data. Over the years, the most common standard has been two successive quarters of contracting economic output, usually measured as GDP. GDP contracted in the first quarter. We won’t know if the second quarter officially contracted until the second quarter GDP number comes out at the end of July. But the Atlanta Fed has created an index to forecast the estimated GDP. As of July 8 (the most recent data available) the second quarter GDP estimate was -1.2%.
Does that mean we are in a recession? Not necessarily. The National Bureau of Economic Research (NBER) is the authority on defining the start and end to a recession, and they look at other criteria in addition to GDP growth or contraction. The NBER definition is “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” Most of those metrics are still strongly positive, which is sending mixed signals.
Let’s Look at Some History
Recessions are usually the result of a specific combination of economic and macro factors. Besides the COVID recession, we have had two other recessions in roughly 20 years.
- The worst recession since the Great Depression was from December 2007 to June 2009. Sparked by a bubble in the real estate that popped, it was severe. Huge corporate bankruptcies and massive consumer mortgage failures led to an ongoing downturn.
- A much briefer recession was the result of the dot-com tech bubble crash. The economy was already in trouble, and the terrorist attacks on 9/11 drove the economy into a brief recession from March -November 2001.
How were these different from now? While the housing market has cooled off a bit due to higher mortgage rates, it’s not a bubble. And more importantly, one result of the 2007 recession is that bank lending standards are now very high, and mortgage default rates are relatively low. Consumer and corporations alike have healthy balance sheets, which gives them the ability to weather a slowdown without causing widespread problems.
What Do the Experts Think?
It depends on which expert you ask. There are a lot of economic indicators, so depending on the ax to grind, experts may favor one over another. Federal Reserve Chairman Powell has been very clear. In his public statements, he has indicated that the Fed’s job is becoming more difficult and that a recession is certainly possible. But the Fed intends to keep raising rates because preventing high inflation from becoming entrenched is the priority. Powell has cited the extremely strong labor market as a cushion to the economy while rate increases do their work.
Consumer sentiment is an important indicator because it is a gauge of consumer behavior – consumers that believe the economy will decline will pull back from spending. The University of Michigan Consumer Sentiment Index is touching lows – but so far, it's not reflected in consumer spending, which remains solid.
Similarly, the increase in mortgage rates has meant that the housing market is cooling, but it’s still very positive. “Cooling” just means that the growth in prices is slowing – not that prices are coming down. Housing inventory remains low, and while housing starts have declined from recent historic highs, they are still equal to pre-pandemic levels.
The equity markets have experienced the worst first half since 1970, and markets are forward-looking. They price in today where the outlook is likely to be six-to-12 months into the future. But mostly, what markets hate is uncertainty. It's impossible to know if the Fed will be successful or if inflation will come down. But as the Fed continues to hold a steady course, more data will be forthcoming.
The Bottom Line
Despite the shock June CPI number – there is already evidence that July will look better, as gas prices have declined significantly. A trend toward falling inflation and a moderating but not collapsing labor market would provide significant reassurance. Even if we enter a recession, given the economy's overall strength, it may be shallow and quickly corrected as the economy gets onto a more normal path.