ECONOMIC REVIEW January 2023

When Will the Much Anticipated Recession Arrive?

Economists have been increasing their recession probabilities for much of the past year, although a recession has yet to arrive. As shown below, forecasters are calling for a recession at a higher rate than at any time over the past 50 years. However, economists do not have a great track record of predicting changes in the economy. For example, at this time last year, the consensus was that inflation would end 2022 at 3.1%, instead of the actual 7.1%. The Federal Funds rate was expected to end the year at 1.1% vs. the actual 4.5%. As Yogi Berra once said, “it’s tough to make predictions, especially about the future.”

Several economic indicators are reasonably good predictors of recessions. For example, yield curve inversion, in which 10-year Treasury yields are lower than 3-month Treasury yields (and stay that way for a few months), has a perfect track record of predicting the last eight recessions, with no false signals. This yield curve, shown below, inverted in late October and will hit its three-month signpost at the end of January. Importantly, the ensuing recession typically takes 12
to 18 months to arrive.

Other economic indicators also have shown deterioration, including The Conference Board’s U.S. Leading Economic Index, which recently turned negative. This Leading Economic Index accurately anticipates turning points in the economic cycle about 7 months in advance, on average. The index turned negative in September 2022 and has declined further since then.

U.S. Leading Economic Index

While there are signs that economic activity is slowing, the economy is still growing. Consumers are still spending, as the savings rate is near the lowest on record. However, the risk of recession over the next 6 to 12 months continues to increase. The hope is that any recession will be mild, with just enough of an economic slowdown to tame inflation. A mild recession is possible as U.S. households are in much better shape than in the recession of 2008, as shown below by dramatically lower consumer debt levels. Similarly, corporate balance sheets are healthier than they were 15 years ago.

Corporate earnings have been declining. Despite positive GDP growth, earnings are expected to have declined 4% in 2022, according to Standard & Poor’s. Earnings and GDP growth often differ for many reasons. Many U.S. companies generate sales from overseas, while profit margins are impacted by higher interest expense. Neither international revenue nor interest expense is included in GDP calculations, causing GDP and earnings to diverge. During a typical recession, earnings decline 20% to 25%, so more potential downside is ahead.

Source: The Daily Shot

Rate of Inflation Remains High But Is Slowing: The Consumer Price Index (CPI) ended the year showing 7.1% inflation, though several components of the index have been easing. For example, after a surge earlier in the year, gas prices ended the year lower than a year ago.

Supply chain disruptions caused about one-third of CPI growth in 2022, but have largely eased and returned close to normal. Another significant portion of CPI is housing, where prices are softening due to much higher mortgage rates. The following chart shows the CPI change and the Underlying Inflation Gauge from the New York Fed, which measures the persistent portion of inflation. All are still inflated, though appear to have peaked a few months ago.

Wage growth is now the key driver of inflation, as the labor market remains historically tight. One factor driving these conditions is the failure of labor force participation to recover to pre-COVID levels, especially among the older cohort in the labor force. It is unclear if this is a permanent or temporary change, although indicators suggest the labor market should soften in 2023, which should reduce wage growth.

While many prices have been easing, “sticky” inflation remains elevated, suggesting the Federal Reserve is unlikely to ease up with its monetary tightening. A longer-term trend that could increase inflation is that many companies will see increased costs from “reshoring,” or bringing manufacturing facilities back to the U.S. Also, prices may be expected to remain high from supply shortages driven by underinvestment in commodities.