May 26, 2022

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Explainer: Recession fears are growing.  But how serious is the danger?

Explainer: Recession fears are growing. But how serious is the danger?

Washington (AFP) – Inflation is at its highest level in 40 years. Stock prices are plunging. The Fed makes borrowing more expensive. The economy actually contracted in the first three months of this year.

Is the US at risk of recession again, just two years after emerging from the last recession?

For now, even the most pessimistic economists don’t expect an economic downturn any time soon. Despite the pressure of inflation, consumers – the main driver of the economy – are still spending at a healthy pace. Companies are investing in hardware and software, which reflects a positive outlook. The job market is stronger Than it has been in years, with strong hiring, massive layoffs and many employers in dire need of more workers.

However, several worrying developments in recent weeks indicate that recession risks may be on the rise. High inflation has proven much more robust than many economists expected. The Russian invasion of Ukraine exacerbated global food and energy prices. Severe lockdowns in China due to COVID-19 have exacerbated supply shortages.

And when Federal Reserve Chairman Jerome Powell spoke at a press conference last week…It cemented the central bank’s determination to do whatever it takes to rein in inflation, including raising high interest rates to weaken the economy. If that happens, the Fed will likely trigger a recession, possibly in the second half of next year, economists say.

By mid-2023, the Fed’s short-term benchmark rate, which affects many consumer and business loans, could reach levels not seen in 15 years. Analysts say the US economy, which has thrived for years on the fuel of ultra-low borrowing costs, may not be able to withstand the impact of much higher rates.

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“Recession risks are low now but have risen in 2023 as inflation may force the Federal Reserve up until it hurts,” Ethan Harris, global economist at Bank of America, said in a note to clients.

The country’s unemployment rate is at its lowest level in nearly half a century at 3.6%, and employers are posting a record number of open jobs. So what would cause an economy with a healthy labor market to stagnate?

Here’s what the path to the eventual economic downturn could look like:

A rate hike by the Fed is sure to slow spending in areas that require consumers to borrow, with housing being the most obvious example. The average 30-year fixed mortgage rate has already jumped to 5.25%, the highest level since 2009. A year ago, the average was less than 3%. In response, home sales fell, as did mortgage applications, indicating a continued slowdown in sales. A similar trend could occur in other markets, for cars, appliances, and furniture, for example.

Corporate borrowing costs are rising, as reflected in increased yields on corporate bonds. At some point, these higher rates may dampen business investment. If companies hold back from buying new equipment or expand capacity, they will also begin to slow hiring.

Falling stock prices may discourage affluent families, who collectively own the bulk of US stock wealth, from spending on vacation travel, home renovations or new appliances. Stock indices have fallen broadly for five consecutive weeks. Lower stock prices also tend to reduce companies’ ability to expand.

Increased caution among businesses and consumers about spending freely could further slow hiring or even layoffs. If the economy loses jobs and public fear increases, consumers will hold back even more from spending.

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The consequences of high inflation will exacerbate this scenario. Wage growth, adjusted for inflation, will slow and leave Americans with less purchasing power. Although a weaker economy would eventually reduce inflation, even then higher prices could hamper consumer spending.

Ultimately, the slowdown will feed on itself, with layoffs escalating as economic growth slows, leading consumers increasingly away from worrying that they might lose their jobs, too.

Economists have explained that the clearest sign of a recession approaching, will be a steady increase in job losses and a rising unemployment rate. As a rule, an increase in the unemployment rate of three-tenths of a percentage point, on average over the past three months, means that a recession will eventually follow.

Many economists also monitor changes in interest payments, or yields, on various bonds for a stagnation signal known as the “inverted yield curve.” This occurs when the yield on 10-year Treasuries falls below the yield on short-term Treasuries, such as 3-month Treasuries. This is unusual, because long-term bonds usually pay investors a richer return in exchange for holding their money for a longer period.

Inverted yield curves generally mean that investors are expecting a recession that will force the Fed to cut interest rates. Inverted curves often precede recessions. However, it may take up to 18 or 24 months for the deflation to occur after the yield curve inversion.

A very brief reversal occurred last month, when the yield on the two-year Treasury fell below the 10-year yield. However, most economists have downplayed its importance because it is short-lived. Many analysts also say that comparing 3-month returns to 10 years has a better track record. These rates are nowhere near reversing now.

At his press conference last week, Powell said the Fed’s goal is to raise interest rates to cool borrowing and spending so companies reduce the number of job openings. Powell hopes, in turn, that companies won’t have to raise salaries as much, thus easing inflation pressures, but without major job losses or outright stagnation.

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“We have a good chance of a soft or quiet landing,” Powell said. “But I will say that I expect this to be very difficult. It will not be easy.”

Although economists say it is possible for the Fed to succeed, most also say they are skeptical about the central bank’s ability to tame such high inflation without ultimately derailing the economy.

“This has never been done before,” said Peter Huber, head of global economic research at Deutsche Bank. “It would be great if the Fed could make that happen.”

Deutsche Bank economists believe the Fed will have to raise its key rate to at least 3.6% by mid-2023, enough to cause a recession by the end of that year. However, Huber suggested that the recession would be relatively mild, with the unemployment rate rising to only about 5%.

Karen Dinan, a Harvard economics professor and former Treasury economist, said she also believes a recession, if there is, will likely be moderate. American households are in a much better financial position than they were before the 2008-2009 Great Recession, when falling home prices and job losses devastated many families’ finances.

“A lot more people have some financial protection,” Dinan said. “Even if it takes a recession to bring down inflation, it probably won’t be as deep or long.”