Two scenarios on the US economy presently dominate economic forecasts. In one scenario, recession is a foregone conclusion—the Fed has raised interest rates so far so fast that a downturn is inevitable, given normal lag times. In the second scenario, a “soft landing” or even “no landing” is still possible. In this version of events, growth slows but does not go negative. Employment is too strong for a full- blown recession; the consumer remains too resilient. Both scenarios can be supported with data, and only time and additional facts will determine which view proves more accurate. The observation that the US economy has proven surprisingly resilient in the face of some of the most dramatic monetary tightening in Fed history is fully supported by sales figures and unemployment numbers. However, it is also true that if we assume a normal lag time between monetary tightening and its impact, the effect of rate increases and reduced liquidity may be just beginning.
In our view, the probability of recession is determined in large part by just how persistent US inflation proves to be. By the end of last year, it appeared that inflation was responding quite rapidly to monetary tightening. Annualized CPI for the final quarter of 2022 came in below 3%. However, much of the improvement was attributable to a decline in gas prices. It also turns out that subsequent adjustments to seasonal factors in the CPI data show that the decline in inflation, while real, was not as dramatic as initially indicated. Even without these factors, it was probably destined to be the case that the easy victories over inflation would come early, and the more entrenched issues would take longer to address. If the tougher elements that are driving inflation require rates to rise to a 6% level and stay there for some time, it is difficult to imagine how we might avoid a full recession. If, however, we are close to the end of this cycle of monetary tightening and inflation continues to abate through this year, we may be able to power through a period of relatively flat growth without a full-blown recession.
US real GDP ended 2022 on a relatively strong note—final quarter GDP came in at 2.7% and full-year GDP came in at 2.1%, despite two negative quarters at the beginning of the year. Current measures of growth are more mixed. Manufacturing ISM for February came in at 47.7%, a slight uptick from January, but still in “contraction” territory (ISM is a “diffusion” index; any read below 50% signals contraction). Services ISM came in at 55.1%, following a similarly strong January number. ISM numbers have signaled contraction in manufacturing for four months running. They have also signaled expansion in the services sector consistently since the end of COVID lockdowns. Demand for goods was pulled forward during COVID, and manufacturing was disproportionally impacted by supply chain issues. Services, which comprise a much larger portion of the US economy, are catching up to demand that was pent up during lockdowns. Personal spending increased 1.1% in January, and retail sales jumped a surprising 3%. Retail sales are not adjusted for inflation.
Housing may be the sector most sensitive to increasing interest rates. Thirty-year mortgage rates currently stand at 6.65%, down from over 7% last November, but well above the sub-3% levels of 2021. New home sales jumped 7.2% in January, but that was a one-month reversal of a more protracted downward trend. The three-month average volume of new home sales is 626,000; down from over 1 million in 2020, but not out of line with volumes seen before the pandemic. Existing home sales came in at an annualized volume of 4.0 million units, over 36% below their pace in January 2022. Median prices have come down marginally, perhaps because inventories remain very tight.
As is typically the case, the US consumer continues to drive growth in the domestic economy. However, savings rates are down, household debt is up, and confidence is waning. The growth is real, and so are the headwinds.
Source: U.S. Bureau of Economic Analysis, fred.stlouisfed.org