As the U.S. economy continues to cool down, there is a growing debate over when (rather than whether) the ongoing slowdown will morph into a full-fledged recession. In fact, the real argument is about the timing and depth of the coming downturn.
Some analysts even believe that the U.S. is already in a recession. Given the heightened uncertainty surrounding the near-term economic outlook, there is a need for an objective assessment of the risks and headwinds facing the American economy.
It is helpful to clarify what economists mean by a recession. The National Bureau of Economic Research (NBER), the official arbiter of business cycle turning points in the U.S., identifies and dates recessions based on “a significant decline in economic activity that is spread across the economy and lasts more than a few months.”
Besides closely monitoring the “expenditure-side and income-side estimates of real gross domestic product (GDP and GDI)”, NBER also uses a variety of other indicators of real economic activity, including “real personal income less transfers, nonfarm payroll employment, employment as measured by the household survey, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, and industrial production.”
It is possible that incoming data initially indicate that the U.S. experienced two consecutive quarters of negative GDP growth during the first half of 2022. But it is worth noting that two consecutive quarters of negative GDP growth, while often a useful rule-of-thumb, is not the official definition of a recession in the U.S.
The third estimate of real GDP indicated that the U.S. economy shrank in the first quarter of 2022. But much of the weakness was concentrated in international trade and inventory (two highly volatile components). Meanwhile, consumers continued to spend on services, and businesses continued to invest in equipment and software. There is a distinct possibility that annual revisions of National Income and Product Accounts (NIPA) data (expected this September) will result in a substantial upward revision of first quarter 2022 GDP data.
Such an outcome is likely due to the larger-than-normal gap between GDP and GDI data for the first quarter of 2022 — GDI was +1.8 percent while GDP was -1.6 percent (on an annualized basis). GDI is often assumed to be a better real-time indicator of economic conditions, and, in the past, the statistical discrepancy between the two has typically been resolved with GDP getting revised to match GDI. Labor market strength in early 2022 also lends credence to the notion that GDI better reflects underlying economic conditions.
So, while the U.S. economy may have avoided falling into a recession during the first half of 2022, it is definitely not out of the woods. In fact, there are signs that an economic downturn may be hard to avoid over the next 12 months as American households and businesses become increasingly fearful of fast-approaching headwinds.
A few recession indicators with a strong historical track record are worth monitoring for incipient signs of a downturn. The 2-10-year segment of the U.S. Treasury yield curve has already inverted, and the 3m-10y segment of the yield curve is expected to invert in the not-too-distant future as the Federal Reserve continues its accelerated rate-hike cycle.
Besides yield curve inversions, the so-called Sahm Rule offers a labor market-based recession warning signal. The Sahm Rule “identifies signals related to the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to its low during the previous 12 months.”
The headline unemployment rate has been stuck at 3.6 percent in recent months. While non-farm payroll data appear to indicate a still-robust labor market, household survey data suggest that labor market conditions are starting to deteriorate. Rising jobless claims offer another sign that the labor market may be weakening. Tech giants are limiting their hiring, and several corporations have announced job cuts.
Declining consumer sentiment and falling real incomes also highlight the growing risk of a recession. With the Federal Reserve expected to raise its policy rate by another 75-basis point this week (and with further tightening ahead), households (and businesses) are yet to fully experience the economic pain from high interest rates.
The severity of any potential downturn will depend on the extent to which household and corporate balance sheets are negatively impacted. A sustained period of falling asset values and surging borrowing costs will raise the risk of a deeper recession. The drop in financial asset values so far has not been severe enough to raise serious concern either at the Fed or among economists.
While the recent surge in high-yield credit signals a rapid tightening of credit conditions, overall financial conditions and healthy bank balance sheets suggest that, despite a few hiccups, the risk of a serious financial dislocation is quite limited.
The housing market may prove to be the ultimate wildcard in this economic cycle. The once red-hot housing market is finally starting to cool and, so far, despite rising mortgage rates and easing demand, the odds favor a soft landing in the real estate sector.
But if interest rates were to surge more than expected and if financial conditions were to deteriorate suddenly, the potential for a sharper downturn in real estate activity cannot be ruled out. Investors have an unusually large exposure to the housing market, and any rush to the exit may trigger a sharp home price correction that affects household and financial sector balance sheets and generates real economic pain.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.