If There Is a Recession, It Has Already Happened

A recession in 2023 seemed to be the consensus coming into the new year. That is no surprise, given that last year delivered the highest rate of inflation, the most monetary tightening in four decades, and an inverted yield curve. Strong January economic data—especially the U.S. employment report—may cause many forecasters to change their minds or delay the timing of an expected downturn to later in the year. But if this cycle ends up being designated as a recession, it’s already been underway for many months and will probably be over by the spring. 

Recessions are typically generated by sharp declines in interest-rate-sensitive sectors, like housing and manufactured goods, and we have been experiencing that for quite some time. 

• Housing is clearly in a recession that began almost a year ago. Mortgage rates more than doubled, and home sales have declined for 11 consecutive months—amounting to a cumulative drop of nearly 40 percent. House prices and rents have been falling since last summer. 
• Consumer spending on goods in real (inflation-adjusted) terms peaked in mid-2021. This followed a surge when many services such as travel and dining at restaurants were off-limits, forcing people to spend a lot more time at home. The decline accelerated toward the end of last year following consumers re-engaging in those services and a huge rise in interest rates. 
• Retail sales in November and December plunged at a double-digit annual pace, forcing retailers to discount items to eliminate excess inventories, cancel expansion plans, and reduce their workforce. 

That is what happens during recessions. The technology sector is also contracting following a COVID-induced boom in the demand for tech services like online shopping, food delivery, streaming services, and remote work and video conferencing. Just like the retail industry, tech companies expanded their capacity to an extent that turned out to be excessive.

Normally, all of that would be enough to crash the economy. But the COVID experience delivered several unusual developments that allowed the economy to hold up unusually well: 

• A combination of factors—including early retirements, less immigration, people either sick or caring for someone who is, and a dearth of childcare services—produced a massive shortage of labor. Job openings peaked at a record 11.5 million and there are still 11 million openings compared with less than 6 million people unemployed. That has allowed the economy to continue generating strong job growth even as labor demand weakens. As a result, household income isn’t getting hit nearly as hard as it usually does, mitigating the spread from the cyclical sectors to the rest of the economy.
• Household and business balance sheets have remained relatively healthy, supported by huge income and wealth gains generated by unprecedented monetary and fiscal stimulus. Households were able to build up a huge stock of excess savings that they are still digging into to support spending. In addition, consumers and businesses did not take on excessive leverage and debt to the degree usually seen in the later stages of economic recoveries. 
• Energy and other commodity prices have fallen sharply, contrary to the experience during the great inflation of the 1970s and early 80s. The decline in gasoline and natural gas prices has boosted household purchasing power, while sharp drops in lumber and steel prices have helped keep production costs under control.

The path of the economy going forward will be determined largely by the future path of inflation and how central banks respond to it. Fed tightening is working: the cyclical sectors are getting clobbered, and most asset prices—including stock and bond prices—have fallen significantly. Most important, inflation has diminished at an extraordinarily rapid pace. 

The oft-quoted year-on-year deceleration does not capture the true extent to which inflation has collapsed in recent months. 

• Between June and December of 2022, headline CPI dropped from 9 percent to 6.5 percent. However, overall prices have been flat for the past 2 months (i.e., zero headline inflation).
• Much of the recent weakness in inflation is due to the sharp drop in energy prices, but that may not continue. 
• However, core (excluding food and energy) inflation—the Fed’s focus—has also decelerated impressively. Core CPI has been running at an annual rate of only 3.1 percent over the past three months, while the core PCE—a different measure of inflation that the Fed officially targets—was up 2.9 percent, already coming close to the Fed’s objective of 2 percent. 
• Even more encouraging is that it is likely to slow even further. Shelter costs—which account for over 40 percent of core inflation—ran at an annual rate of over 9 percent during this same period but will likely decelerate going forward. Federal housing agencies, brokerage listing services, and other private data sources show that both house prices and rents have been falling since last summer. This will be captured eventually in the official inflation data, which uses an average of rents over the previous 6 months to estimate monthly changes in shelter costs. 

With that kind of progress on inflation having already occurred and with more in the pipeline, the Fed hiking regime should be close to an end. Market pricing suggests that the Fed will complete this hiking cycle by the spring with a Fed funds rate of around 5 percent or a bit higher, which seems reasonable. But market expectations of rate cuts in the year’s second half will probably not be realized. 

• The cyclical sectors of the economy are close to a bottom, making a significant deterioration in the economy later this year unlikely. 
• On the contrary, a bounce in the economy beginning in the spring or summer seems more probable than a further deterioration. If the recent drops in mortgage rates and house prices are maintained, a pickup in sales sometime later this year would not be surprising. Meanwhile, excess inventories in the retail industry will probably be eliminated in no more than a few months.  
• While inflation is coming down much more quickly than expected, the Fed will want to ensure that it stays that way and doesn’t pick up again.

All of these things have implications for the financial markets. Current stock prices seem broadly consistent with a very mild economic downturn, as the cumulative decline since the beginning of last year is significant but less than the typical recession. The S&P fell almost 20 percent last year after a 27 percent surge in 2021. So far, it’s up this year for a net peak-to-trough decline of around 15 percent. That compares with a mean drop in the S&P during recessions of 29 percent. That said, it seems too early to be overly bullish. 

• Most valuation measures suggest that stocks are not cheap, and a strong economic rebound seems unlikely anytime soon.
• In addition, profit margins have peaked, and bond yields are likely to remain considerably higher than they were a few years ago.

Bond yields are trending higher than they were before the pandemic, and that is consistent with the surge in inflation and higher Fed policy rates. The yield on 10 U.S. Treasuries is currently at the bottom of the 3.5-4.25 percent range that they have been in since the fall. While that is well above the 1.5-3 percent range that persisted for a decade before COVID, the change in economic fundamentals since the pandemic suggests that bond yields are likely to end up closer to the top end of that range or even a bit above it.

• The U.S. budget deficit is significantly larger, and the Fed will not resume buying bonds again for the foreseeable future.
• Zero policy rates are a thing of the past.
• While inflation is on a significant downtrend, structural changes suggest it will not settle as low as it was pre-pandemic when inflation was often below the Fed’s target of 2 percent. 
• International trade has peaked, and companies no longer use cost as the sole factor in deciding where to produce or buy inputs from. Instead, they are diversifying their supply chains and placing more emphasis on reliability and safety.

The U.S. is one of many countries where economic prospects are outperforming consensus forecasts. 

• China recently announced a sharp reversal of its zero-COVID policy, setting the stage for a rebound from a period of unusually slow growth. 
• Europe’s outlook has also brightened considerably, as energy shortages resulting from the war in Ukraine have been much less severe than was feared. The weather has been warmer than anticipated, and countries have been able to build oil and gas stockpiles from non-Russian sources. As a result, natural gas prices have fallen back below pre-Russian-invasion levels, a very positive surprise. This means that the deep recession forecast for the Euro area no longer looks likely. 

The bottom line is that 2023 doesn’t look nearly as bleak as consensus economic forecasts and financial news reports suggest. The inflation surge is evaporating quickly, Fed rate hikes are near an end, and a recession—if it ends up being designated as such—has already occurred, and it’s much less painful than usual.