A Recession Is Expected, But Is It A Sure Thing?

It’s been a rough 2022, but the U.S. economy survived the myriad of headwinds thrown at it, including raging inflation, geopolitical stress, a slowdown in housing, skyrocketing interest rates, declining stock prices, the worst year for bonds of all time, a recurring Covid-19 wave, and the most aggressive pivot towards monetary tightening in more than forty years. Against this backdrop, it’s hard to believe that the nation avoided a recession – a tribute to the economy’s resilience under pressure. But as the curtain rises in 2023, that resilience will be tested again, and it will take a bit of luck to avoid a recession next year as market headwinds remain.

How well the economy holds up will depend on some unresolved questions. How hard will the Federal Reserve keep pushing on the brakes? How will the inflation outlook unfold? Will the job market stay strong? Will consumers, the economy’s main growth driver, keep spending? To be sure, these questions are interdependent, so the answer to one will influence the others. But the bigger picture can only come into focus by examining each one and how they interact.

Even if a recession unfolds next year, the question remains, how severe will it be? From our lens, the economy will likely suffer a downturn by mid-year. But it should be relatively mild unless some unexpected shock delivers a more severe blow and amplifies the headwinds that are already gaining
traction. We also can’t dismiss the uncertainties linked to the war in Ukraine and lurking risks in the financial system (Crypto – we’re looking at you).

Will The Fed Pause Or Pivot?

The biggest threat to the economy in the coming year is that the Federal Reserve goes too far in its quest to curb inflation. Some believe it’s already time to pause the aggressive rate-hiking campaign that has been underway since March, punctuated by the latest half-percentage point increase in the Fed’s target rate on December 14. With that increase, the central bank has lifted its policy rate by more than 4 percentage points, the steepest increase in so short a time span on record. Keep in mind, at the beginning of the year, market expectations were for a mere 3-quarter-point increase in the fed funds rate. The era of cheap money has fallen by the wayside, and many borrowers are feeling the pain, particularly those seeking mortgages to buy a home or loans to purchase a vehicle.

But the full impact of the Fed’s rate hikes is yet to be felt, aside from the profound damage in interest rate-sensitive sectors like housing, autos, and high-growth tech. It’s an accepted principle that changes in interest rates affect the economy with long and variable lags. Because the rate hikes so far have been
condensed and sharp, the lag has no doubt been somewhat shortened. For example, the spike in auto loan rates is likely contributing to the slump in car sales, although parts shortages that have curtailed supply have also played a significant role. But the broader and more severe impact will be felt next year,
and no one knows how much damage to economic activity will ultimately play out.

At the last policy meeting in mid-December, Fed officials expected to raise rates by another three-quarters of a percentage point in early 2023, lifting the target federal funds rate to a range of 5.1%-5.4% and hold it there for the rest of the year. That’s a half percent higher than the Fed projected as recently as September and higher than many think the economy can bear. Indeed, the financial markets believe rates
that high will surely bring on a recession and prompt the Fed to pivot towards cutting rates as early as the end of next year. That may well occur, but Fed chair Powell has steadfastly asserted that policy will stay on course for as long as it takes to stifle inflation, even if it brings on a recession.

Making Up For Lost Time

Historically the Fed has maintained that its policy decisions are data-dependent. When the facts change, officials often change their minds. But that hasn’t always been the case. Recall that inflation was dormant for a decade before the pandemic broke out suddenly in 2021. But as inflation accelerated, the Fed ignored the facts – believing the acceleration to be transitory – and kept a lid on interest rates. By the time they acknowledged that the facts had changed and inflation was becoming more entrenched in the economy, they finally changed their minds – and did so with a vengeance, as evidenced by the highly hawkish pivot towards restrictive monetary policy in 2022.

In the eyes of many, the abrupt about-face reflects a desperate effort by the Fed to make up for lost time and restore credibility. The unprecedented swift and sharp rate increase over the past eight months was taken to compensate for the delayed response that should have started at least six months earlier. In a sense, the Fed violated its long-held principle that waiting too long to curb inflation inevitably requires harsher measures later to bring it to heel. Had the Fed started raising rates earlier, they might have had to raise them less than they have, and inflation might have gained less traction.

To be fair, the inflation outbreak did have transitory elements ignited by factors the Fed could not control. Their tools are designed to influence demand, but supply shocks were the primary inflation catalyst early on. Also, the trillions of dollars of fiscal support meant to cushion the economy from the pandemic made the Fed’s job of curbing demand that much more difficult, as those funds poured into the spending stream and gave households the financial muscle to afford the higher prices on goods and services.

Inflation Has Peaked

The supply-chain snarls that underpinned the inflation surge in 2021 and early 2022 have mostly healed. U.S. retailers and factories no longer have difficulty getting goods to sell or to complete the production process. The logjam at ports has cleared, and shipping costs have fallen sharply in recent months. Many retailers are stuck with excess inventories, prompting deep discounts to clear shelves. Amazon held two-Prime day sales over the summer, and other high-profile retailers followed suit.

Indeed, the goods shortage that catalyzed inflation last year is now having the opposite effect. Prices of goods have fallen for four consecutive months through November, contributing to a marked slowing of inflation. Both an abundance of supply thanks to unclogged supply chains and changing consumer
buying patterns as people return to normalcy have dragged goods prices lower. Americans are going to concerts, sporting events, traveling, and generally partaking in leisure and hospitality experiences, all of which were shunned when the pandemic kept people indoors and heightened the demand for physical goods that made living spaces more tolerable.

As consumers spend more of their dollars on services, the demand for goods has softened even while inventories have piled up. At the same time, the financial muscle provided by generous government stimulus checks during the pandemic is fading. Households built up a formidable cushion of pandemic
savings that powered consumption even as inflation robbed the purchasing power of low and middle-income families. But that savings cushion is drying up. It is estimated that more than a trillion dollars of excess savings still reside in bank accounts. But most – and by now nearly all – of that is held by upper-income families that tend to save rather than spend their incremental wealth.

Labor Costs Are Key

Consumer price increases are slowing due to the combination of softer demand for goods, increased supply, and diminished household purchasing power. In November, the annual inflation rate, as measured by the Consumer Price Index, slipped to 7.1%from a peak of over 9% in June. The Fed uses a different
inflation gauge, the personal consumption deflator, as its yardstick, which is running about a percentage point lower. Even so, there is a wide gap between the current rate and the Fed’s 2% target.

Reaching that target will take work. As noted, the low-hanging fruit has been picked as goods prices follow the laws of supply and demand and are heading steadily down. But goods constitute less than 40 percent of what consumers buy; the more significant challenge is to slow service prices, which are
stickier and remain stubbornly high. Of course, that’s where the rubber meets the road regarding the economic outlook. Most service providers, such as restaurants, rely heavily on workers to generate revenues, making labor costs their most considerable expense. In turn, the pickup in wage growth over the past year is a crucial reason inflation in services has remained elevated. Fed chair Powell has understandably pointed out that inflation is not likely to slow to 2 percent as long as wages increase by the current 5% growth pace.

Not surprisingly, the Fed’s deep concern about inflation is linked to the ongoing strength in the job market, where there are about twice as many job openings as unemployed workers. Hence, workers are in the driver’s seat, putting upward pressure on wages. The Fed’s goal is to reduce those pressures without
causing a severe increase in unemployment, gliding the economy into a “soft landing.” Ideally, the rate increases would narrow the gap between job openings and unemployment, thus lessening competition for workers and weakening workers’ bargaining positions. There is evidence that the gap is closing as
new job listings are falling and some sectors, such as technology, are laying off workers or instituting hiring freezes.

But wage growth has yet to slow, and the Fed is committed to keeping its foot on the brakes until it does. Their latest projection sees the unemployment rate rising 0.9% to 4.6% in 2023, and the economy has never avoided a recession when the rate increased by more than 0.5%. Historically, it has been difficult to slow the pace of job destruction once it starts, leading to a snowball effect of layoffs and thereby deepening a mild recession into a more severe one.

There are reasons to believe this time could be different. No glaring imbalances in household or business balance sheets which typically precede a sharp downturn. Consumers and corporate America have never been better positioned for a slowdown in growth. Moreover, businesses are likely to retain more workers than otherwise in the face of a slowing economy due to the severe labor shortages over the past year. The greatest risk stems from an over-restrictive Fed that disregards the lagged effects of the most rapid rate hike cycle of all time. There’s still time for the Fed to ease up on monetary policy next year; if they choose to do so, a recession can still be avoided.

If you are a Legacy client and have questions, please do not hesitate to contact your Legacy advisor. If you are not a Legacy client and are interested in learning more about our approach to personalized wealth management, please contact us at 920.967.5020 or connect@lptrust.com.

The information contained herein is for informational purposes only and does not constitute a recommendation or advice. Any opinions are those of Legacy Private Trust Company only and represent our current analysis and judgment and are subject to change. Actual results, performance, or events may differ based on changing circumstances. No statements contained herein constitute any type of guarantee, nor are they a substitute for professional legal, tax, or other specialized advice.