REAL ECONOMY BLOG | July 17, 2023
Authored by RSM US LLP
A rapid decline in inflation amid robust hiring and an unemployment rate that stands at 3.6% despite a steep rise in interest rates underscore a resilient American economy that refuses to go gentle into that good night.
That reality, reflected by what looks to be growth near the economy’s long-term trend of 1.8% in the first half of the year, has resulted in our reduction of the probability of a recession over the next 12 months from 75% to 60%.
We have rolled back our probability of a recession over the next 12 months to 60%, reflecting a rising chance of a soft landing.
We expect growth in the current quarter to slow to roughly 0.5% and then possibly contract in the final quarter as the lagged impact of tighter monetary policy that has pushed up the cost of doing business acts as a drag on overall economic activity.
Should our forecast come to pass, then the economy would observe a 0.6% seasonally adjusted annualized rate of growth this year, or what we refer to as muddling through.
Moreover, that rapid decline in inflation from 9.1% a year ago to 3% in June as the central bank has raised its policy rate has caused real interest rates to rise, which is dampening risk taking in areas like private equity and among the once-booming tech and life sciences sectors.
Until the Federal Reserve finishes its rate hikes and inflation stabilizes, the appetite for risk inside the real economy will remain muted.
Whether the slower pace of growth will be sufficient for the National Bureau of Economic Research to call it a recession is open to question. From our vantage point, it will likely not, and we think that a recession, if it were to happen, would require an exogenous event through the global energy market or another shock via the financial channel, likely among local and regional banks sitting on nonperforming commercial real estate loans.
We have thought for some time that the difference between sluggish growth and a recession will be reduced fixed business investment driven by tighter financial conditions. That outlook has not changed, and during the first half of the year that reduction has been offset by robust hiring and strong consumer spending.
With roughly $670 billion in excess savings among households, most of it sitting in the accounts of the upper two income quintiles, there is enough savings to avoid a domestic recession and continue to offset areas of the economy that are contracting, like manufacturing.
That implies that the probability of a soft landing of the U.S. economy has improved to 40%, a nontrivial estimate, as employment remains robust, household spending holds up and a nascent boom takes place in manufacturing construction linked to recent changes in public policy.
All of those factors point to the economy muddling through the twin shocks of elevated inflation and higher interest rates that the economy has absorbed over the past two and a half years.
Rate peak in sight
Given the improvement in the inflation outlook, we expect that the Fed will raise its policy rate to a range between 5.25% and 5.5% at its next meeting.
While it is possible that increase will represent the policy peak of the central bank’s efforts to restore price stability, the Fed may need to hike its policy rate further in September should it not observe improvement in top-line inflation, core services excluding housing inflation and core inflation excluding food and gasoline.
We do not anticipate that the Fed will cut its policy rate this year unless the unemployment rate rises to above 4.5%, which we don’t see until early next year if at all.
We have marginally increased our call on long-term rates and now expect the 10-year yield will finish the year at 3.8%, up modestly from our 3.75% expectation at the outset of this year. We expect the two-year yield will finish the year near 4.1%.
All of which brings up an important point: Unlike the giant U.S. financial sector, the nonfinancial firms that comprise the overwhelming majority of the real economy largely do not care about day-to-day volatility in short-term rates. Rather, they care deeply about long-term rates.
If the Fed is approaching its peak in rates for this cycle, pushing inflation down toward its 2% target will require the onset of deflation via the trade channel—think China—a recession, or higher rates at the long end of the curve. One way to push these long-term rates higher is for the Fed to draw down its balance sheet more aggressively, or what is commonly referred to as quantitative tightening.
While that would create further risk of financial tightening and a near term contraction in the economy through the financial channel, if the Fed is going to reach its policy objective of an average 2% rate in the core personal consumption deflator it will have to consider that.
Stay tuned because we think that this is going to be part of the policy narrative over the next two years as core inflation remains closer to 3% than the central bank’s 2% objective.
It is understandable why many focus on what’s wrong with the economy because of the difficult adjustment to higher prices and interest rates over the past two years.
But with a rapid unwind of inflation amid declining oil, gasoline and goods prices, it is time to focus on what is driving overall economic activity.
Labor demand: First, labor demand has proved far more durable than one would have expected because of financial tightening and a rising cost of doing business. Through the first six months of the year, the economy has generated 1.7 million jobs and the unemployment rate has ranged between 3.4% and 3.7%.
Inflation-adjusted average hourly earnings have increased by 1.2% while the Atlanta Fed wage tracker indicates wages are up by 5.6% on a nominal basis. That would imply that with overall inflation at 3%, real wages are on track to observe strong gains, which tends to support spending. With inflation likely to finish the year near 2.8%, households will most likely experience further increases in real wage gains that support overall spending and economic activity.
We expect hiring to cool in the second half of the year and the unemployment rate to migrate higher toward 4%—which is consistent with full employment. Those factors should dampen wage growth and ease inflationary pressures.
Household spending: Second, excess savings built up during the pandemic continue to be the primary cause of growth. Household spending, despite the lagged impact of rising rates and inflation, expanded at a 2% rate in the first quarter and will most likely do so again in the second. The combination of real wage growth and excess savings should be sufficient to support a less than 1% growth in overall economic activity.
While it is clear that lower-income households remain under duress, the spending of upper-income consumers remains solid. As long as that is the case and employment does not turn over, the economy will escape the NBER’s definition of a recession.
Residential construction: Third, over the past year and a half, the residential construction was clearly in recession even if the overall economy was not. Yet it would appear that residential construction has bottomed, and forward-looking permits data imply a move toward 1.5 million housing starts at annualized pace up from the cyclical low of 1.34 million posted in January.
Despite elevated mortgage rates near 7%, there is simply a lack of supply that will take several years of starts near an annualized pace of 1.7 million if home builders are to catch up to demand.
Manufacturing construction: Finally, the tailwind occurring inside the manufacturing construction sector is something to behold. Manufacturing construction has been growing at a whopping 74% yearly rate during the first six months of the year.
That growth can primarily be attributed to the effort to rebuild U.S. computer chip manufacturing. But other sectors like transportation, chemicals, and food and beverage are holding their own and it is expected that policy-induced building linked to the bipartisan infrastructure legislation will bolster outlays.
Perhaps more important, it will most likely prove sufficient to push the manufacturing sector that is caught in a period of mild contraction back into the black.
Risks to the outlook: Financial tightening
The primary risk to the outlook is the lagged impact of financial tightening by the Federal Reserve. With 500 basis points of rate hikes over the past 15 months and a possible 25 or more to go, there is the case to be made that overall higher rates will at one point cause the economy to slip into recession.
Indeed, the major financial event of the first half of the year was the turmoil among small and midsize banks, and the efforts by the Fed and Treasury to prevent a classic bank run.
Those banks, where many middle market firms park their cash and borrow to expand their firms, remain under duress as rates move higher. These banks also hold approximately 70% of all commercial real estate loans—90% of those loans outside the major metropolitan areas—and will experience further lateral pressure. This year, $270 billion in commercial real estate loans are coming due; that figure rises to nearly $1.5 trillion by the end of 2025.
Stricter lending standards are the sword of Damocles hanging over the real economy. It has suppressed demand for commercial and industrial loans that small and midsize firms use to meet payroll and finance expansion.
That data implies that we are not finished adjusting to the interest rate shock. Firms would be wise to focus on developments at the long end of the Treasury curve and the pace of quantitative tightening.
About that recession: False positives
Talk around recession soared as local and regional banks sought to right the ship earlier this year. Indeed, just about every version of the yield curve—whether it was the 2/10, 5/30, 3 month/18 month or 3 month/2 year—all inverted and pointed toward recession.
But so far, the information derived from a variety of yield curves has provided false positives on an overall recession.
Instead, the U.S. economy has proved far more resilient and less sensitive to interest rate hikes than it has in past business cycles.
Part of this has to do with pandemic-era fiscal policy put in place in 2020 and 2021. Structural changes inside the service sector and the fact that a large majority of households hold mortgages well below 5% and are still sitting on large equity positions in their homes all point to a resilient economy.
The U.S. economy will most likely continue to muddle through a period of soft growth as it adjusts to elevated inflation and higher interest rates. Robust labor demand, solid consumer spending, modest residential construction and a nascent manufacturing renaissance will all prove to be tailwinds for the economy.
For these reasons, we have rolled back our probability of a recession over the next 12 months to 60% and think that there is a 40% probability that the Fed achieves that much talked about but seldom achieved soft landing.
This article was written by Joseph Brusuelas and originally appeared on 2023-07-17.
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