Economic Update Spring 2023
The U.S. is currently in late cycle but a recession this year appears likely. Higher interest rates are weakening consumer demand, making it more expensive to live, and now contributing to bank failures. Household debt/service payments as a percentage of personal income is rising – Household operating cost rising! Chicago Fed National Financial conditions at tightest levels since May 2020. Credit spreads were widening early March over worries of more regional bank failures and have come off their highs. Wider credit spreads are an ominous sign of a recession on the horizon. The Fed’s aggressive tightening campaign is working. Liquidity that contributes to inflationary pressure is rapidly being drained from the U.S. economy. The supply of money is declining at the fastest pace since the Great Depression. Apparent end-of-cycle dynamics exhibiting themselves include slowing economic growth, rising inventories, declining profit margins, tightening credit conditions, contractionary monetary policy, rising unemployment claims, and inflation is moderating.
The latest GDPNow model estimate for real GDP growth in the first quarter of 2023 is 2.5%. Low unemployment is boosting personal income and consumption that normally would be lower after one year of rate hikes. Moody’s analytics baseline forecast for 2023 economic growth projected to be 1.9% - no recession. It is hard to believe the US economy will not slide into a recession with so many recession indicators triggering recession alert alarm. The Treasury yield curve is inverted in most parts. Ed Hyman, ranked the top economist for more than four decades by Institutional Investor, said Fed should stop hiking because the US economy is slipping into a recession.
The regional banking crisis is likely to lead to a significant slowdown in lending. Housing is the first sector to respond to higher rates…employment is last. Unemployment and inflation are lagging indicators. The Fed can ease off the brakes at this point without worrying that inflation will stage a rebound. The full effects of its tightening cycle are beginning to impact the US economy. Before a recession, jobless claims rise, and wage growth slows. Both factors are happening now. However, unemployment is still low not anywhere near recession levels. In a garden variety recession - unemployment rises to about 6%. Today it is 3.5%, layoffs are coming in my view. Millions must be laid off before a recession can be called. A significant rise in unemployment is the telltale indicator of every recession. Although, I do not think that will happen this time around with a shortage of labor – baby boomers are leaving the work force. By the time unemployment rises enough to cool inflation enough to satisfy Fed’s goal, US economy will be in a recession requiring Fed to cut rates.
The bond market is already predicting a recession and has a good record of being right. The Yield curve has inverted, notably in the most reliable part, 3 months – 10 Years, which signal a recession ahead. Inverted yield curve signals slowing economy and lower inflation ahead. Lag effects of one of the fastest tightening cycles in history, is just hitting economy now. Tightening is showing up in economic data. The ISM’s Services Index, another reliable recession indicator, is barely at expansion level. The ISM Manufacturing Index fell to a three-year low and deeper into contraction territory in March. The Conference Board Leading Economic Index (LEI) for the U.S. fell again in February, marking its eleventh consecutive monthly decline. The LEI points to risk of recession in the US economy. In the past, year-over-year declines of current magnitude since the 1950s have ended in recession according to The Conference Board. Similarly, the ratio of leading indicators to lagging coincident indicators peaked and rolled over. That too is a strong indicator of a looming recession.
The most recent financial turmoil in the U.S. banking sector is not reflected in the LEI data but is highly likely to lower future lending and consumption pushing the economy into a recession. The Fed continues to tighten knowing that monetary policy is characterized by long, variable lags. Its tightening campaign is beginning to weigh on economic growth. As the economy slows, inflation should fall even further towards the Fed goal at the expense of job layoffs. I worry that the Fed’s actions create financial instability in the form of a credit crisis.
Inflation continues to moderate as the Federal Reserve’s interest rate hikes slow economic activity. In March, the Consumer Price Index (CPI) rose 5% from a year ago, far off its 40-year high of 8.5% last year. Many indicators such as import, and export prices are declining faster than they rose. Producer Prices paid plunged in March to a year-over-year rate of 2.7%. The personal consumption expenditures price index excluding food and energy, the Fed’s preferred inflation indicator, rose less than expected in February. On a 12-month basis, core PCE increased 4.6%. Shelter costs, which make up about one-third of the CPI index’s weighting, could be peaking. The Federal Reserve expects housing costs and rents to slow over the course of the year. Housing costs are a key driver of the inflation figures, but they are also a lagging indicator. Overall, a CNBC survey reports Household budgets are really being squeezed by inflation. 1 Year TIPS Breakeven show the Fed being successful at bringing down inflation over the next twelve months, which bodes well for a rate cut by 2024 or sooner depending on the level of inflation. Lower inflation over the next twelve months supports consumption, Fed rate cuts, and a smaller decline in corporate profits.
Initial claims are beginning to rise from lows, the 4-week moving average rose to 240,000 in April. The economy needs 300,000 plus initials claims to say economy is in a recession. Initial jobless claims have recently been under reported by the Labor Department. Claims are now showing a less sanguine employment picture reflecting recent headline job layoffs. Initial claims are a leading indicator closely watched to anticipate a recession.