Is the US economy already in recession?

TD Securities doesn’t think so. But it does warn that “the risks of a 2022 recession have increased after recent data, and we now see 60% odds of a recession within the next 12 months”.

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  • The recent souring in economic data has raised fears of an imminent US recession. In this note, we discuss the likelihood of a “technical recession”, how this differs from a recession defined by the National Bureau of Economic Research (NBER), and why we believe that a technical recession may be
    obscuring strong underlying growth in the near-term.
  • We continue to judge that the US economy is currently not in recession even if GDP growth turns out to be negative in Q2. However, the risks of a 2022 recession have increased after recent data, and we now see 60% odds of a recession within the next 12 months.
  • We are now looking for GDP growth to slow further by the end of the year and into the beginning of 2023. That said, we expect the Fed to continue tightening policy “expeditiously” to above its estimate of neutral by the end of the year despite rising recession odds and continue to see a terminal Fed funds rate of 4%.

The recent souring in economic activity data has raised fears of an imminent US recession. Following the 1.6% q/q AR contraction of GDP in Q1, another retreat in output in Q2 would trigger what is known as a “technical recession” — two consecutive quarters of GDP contraction. This scenario has become more likely over the past week.

The second revision to Q1 national accounts unveiled a larger accumulation of inventories than initially reported: the change in inventories was revised higher to $188.5bn from $149.6bn. While that meant a larger contribution from inventories to Q1 GDP growth, this will also mean that the handoff to Q2 is significantly less favorable given that inventory accumulation will be markedly lower than in the prior quarter (note that GDP calculations take into account the change of the change in inventories). We are now tracking Q2 GDP growth at -0.8% q/q AR, with inventories subtracting a large chunk of headline growth (effectively prompting a technical recession).

In this note, we discuss the likelihood of a “technical recession”, how this differs from a recession defined by the National Bureau of Economic Research (NBER), and why we believe that a technical recession may be obscuring strong underlying growth in the near-term.

What is a “recession”, anyway?

While the definition of a “technical recession” has become a rule-of-thumb for market participants given that two consecutive quarters of contracting GDP have been associated with past recessions, this is not the official definition of a recession. Indeed, two consecutive quarterly declines in GDP are not a necessary or sufficient condition to determine an actual recession.

According to the NBER, the official arbiter of recessions in the US, a recession involves “a significant decline in economic activity that is spread across the economy and lasts more than a few months.” Based on this definition, we continue to judge that the US economy is currently not in recession even if GDP growth turns out to be negative in Q2. However, the risks of a 2022 recession have increased after recent data, and we now see 60% odds of a recession within the next 12 months.

US private demand

What is the data saying?

At the moment it is difficult to say that the US is currently in a recession. The labor market continues to hum along at very tight levels and domestic demand remains positive. Indeed, Q1 and Q2 GDP calculations have been impacted by large, and likely, one-off quirks in two of the most volatile components: net exports and inventories. Net exports subtracted an eye-popping 3.2pp from headline GDP growth in Q1, and we currently project inventories to reduce Q2 GDP growth by a full 2pp.

Meanwhile, domestic demand, a more reliable indicator of economic momentum, has remained perky. Strength in domestic demand is typically not associated with recessions (Figure 1). Furthermore, gross domestic income or GDI — another measure of economic activity that receives less market attention — registered a firm 1.8% q/q AR expansion during the first quarter (Figure 2). This is more consistent with the underlying strength of domestic demand and current labor market dynamics. Indeed, Governor Waller noted that it is unusual to have strong hiring with economic activity going down, and that  perhaps GDI might be providing a better gauge of activity. Note that the NBER uses the average of both real GDP and real GDI to determine the turning points of the business cycle.

The NBER also follows a number of monthly, economy-wide activity indicators in order to assess whether the US economy has entered a recession. These are:

  • Real personal income less transfers
  • Nonfarm payroll employment
  • Employment from the household survey
  • Real personal consumption expenditures
  • Real manufacturing and trade sales
  • Industrial production

Most of these series have held up over the past six months, with the exception of real manufacturing and trade sales, which have been losing momentum recently as they have slipped from extremely strong levels. Interestingly, the NBER underscores that “in recent decades, the two measures we have put the most weight on are real personal income less transfers and nonfarm payroll employment.” We evaluate both series below:

US personal income growth
  • Personal income: As Figure 3 above illustrates, personal income less transfers so far does not appear to be showing signs of rolling over. However, the current trend is not inconsistent with the paths leading to the start of some other recessions (1980 and 2007-08). That said, we would likely need to see some retrenchment in the series in June for it to signal a higher chance of recession in Q2, as was the case in most post-1980 episodes (with the exception of the 1981-82 recession).
  • Labor market: On the other hand, it would be an understatement to say that momentum in nonfarm payrolls has been strong over the last six months. This strength is highly inconsistent with labor market dynamics heading into other recent recessions (Figure 4). Indeed, we would likely need to see a remarkable turnaround in the employment data for it to suggest that a recession is imminent. Indeed, as we have underscored before, labor demand is likely to be key in determining a turn in the business cycle as a worsening labor market directly affects personal income and consumer spending (Figure 5).

The Conference Board’s consumer confidence survey sheds a light on this. While consumer “expectations” have clearly worsened due largely to surging inflation (more visibly in gas and food prices), the “present situation” index, which reflects consumers’ assessment of current conditions, has yet to reflect a comparable retreat (Figure 6). It is no surprise that the “present situation” component of the survey is more sensitive to labor market conditions and that weakness in this measure has usually preceded recessions. As the labor market goes so does the consumer and the economy.

US unemployment rate

Does a recession stop Fed rate hikes?

While we are firmly of the view that the economy is not currently in a recession, a recession may just be a matter of time. We are now looking for GDP growth to slow further by the end of the year and into the beginning of 2023 on the back persistently high inflation and a more hawkish Fed reaction function, which are likely to result in consumers turning more cautious (Figure 7). In effect, we look for the Fed to continue tightening policy “expeditiously” to above its estimate of neutral by the end of the year despite rising recession odds. As was clear from the June FOMC minutes and recent Fed communication, the Fed remains on a path of removing accommodation and actually shifting policy to a restrictive stance as it continues to overweight inflation concerns over their desire to achieve a soft landing.

Fed Chair Powell said as much last month, underscoring that the Fed’s “overarching focus is using [their] tools to bring inflation back down to our 2 percent goal and to keep longer-term inflation expectations well anchored” and that “[t]he American economy is very strong and well positioned to handle tighter monetary policy.” We share that view. This is also why our rates strategy team remains short 2y Treasury yields, expecting the market to pencil in more rate hikes.

US economic forecasts
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