The Recession Mystery: Mid-Year Economic Report

The U.S. economy is following an unusual trajectory, with weakening output but strong job gains. Gross domestic product (GDP), a broad measure of the goods and services produced across the economy, fell at a seasonally adjusted annual rate of 0.6% in the second quarter, following a contraction of 1.6% in the first quarter of 2022. By traditional definition, two quarters of negative growth would mean the economy is in a recession.

However, employers continued to hire at a strong pace, adding 528.000 jobs in July alone. The unemployment rate, a key barometer of economic health, dropped to 3.5% in July (tied for the lowest level since 1969) after holding steady at a low 3.6% for the past four months. Wage growth was stronger than economists anticipated.

Inflation Easing?

The Producer Price Index (PPI), which captures prices paid to producers for their goods and services, slowed in July, which offers some hope that inflation could moderate. According to the Bureau of Labor Statistics, the PPI was 9.8% higher in July 2022 than July 2021, and dropped from a sharp 11.3% year-over-year spike in June 2022. The Consumer Price Index (CPI) for July 2022 showed that the prices Americans pay for everything from food to electricity increased by 8.5% over the past year, a slower pace than the 9.1% increase in June 2022.

The Bureau of Labor Statistics noted that July’s 1.8% drop in wholesale goods prices—the largest monthly decline since a lockdown-triggered plunge in April 2020—is a function of lower energy prices. The agency also attributed 80% of the price decline in goods to a 16.7% drop in gasoline prices from June to July 2022. Average gas prices in July dropped below $4 a gallon for the first time since March 2022, according to AAA.

The U.S. economy remains in a highly challenging environment, with rising prices a continued concern for businesses and policymakers. That concern raises the stakes for the Federal Reserve, which has committed to raising interest rates to tame inflation while trying to avoid triggering a recession.

Analysts noted that much of the decline in the second quarter for the economy was due to a slower pace of inventory restocking. Consumer spending, which accounts for roughly two-thirds of total economic output, rose at a 1.5% annual rate in the second quarter, down from 1.8% in the first quarter.

By defying expectations of an economic slowdown, the strong jobs report will make it harder for the Fed to dial back the pace of rate increases at its meeting in September. The behavior of wages is particularly important to the Fed right now due to concerns that companies are raising wages. The Fed speculates that companies may pass higher labor costs on to consumers in the current inflationary environment.

Meanwhile, the Fed’s preferred measure of inflation showed that price increases slowed in July. The Personal Consumption Expenditures price index released on August 26 rose 6.3% from 2021, lower than the 6.8% year-over-year increase recorded in June 2022.

Who Makes the Recession Call?

Despite the strong jobs report, the GDP results indicate that the economy met a commonly used definition of recession—two straight quarters of declining economic output.

The official arbiter of whether the U.S. economy is in a recession is the Cambridge, Mass.-based National Bureau of Economic Research, a private nonprofit research organization “committed to undertaking and disseminating unbiased economic research.”

The origins of the NBER’s role can be traced to the 1960s when the Commerce Department began publishing a digest that relied on the organization’s analysis of the business cycle. The NBER’s president selects an eight-member Business Cycle Dating Committee, which decides on recession markers. Committee members tend to be distinguished economists. Business cycle dates are determined by the NBER committee under contract with the Department of Commerce. Typically, these dates correspond to peaks and troughs in real GDP, although not always so. The committee’s decisions are not always unanimous, but the disagreements within the panel tend not to be about the presence of a recession; rather, they are about said recession’s specific start and end points.

The NBER uses a broader definition of a recession than commonly appears in the media. While, in common usage, a recession denotes two consecutive quarters of a shrinking GDP, the NBER defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

The NBER prefers this definition for a variety of reasons. First, the NBER believes that measuring a wide range of economic factors, rather than just GDP, presents a more accurate assessment of the health of an economy. For instance, the NBER considers not only the product-side estimates like GDP, but also income-side estimates such as the gross domestic income (GDI).

Second, since the NBER wishes to measure the duration of economic expansion and recession at a fine grain, the organization places emphasis on monthly—rather than quarterly—economic indicators.

Finally, by using a looser definition, the NBER can take into account the depth of decline in economic activity. For example, the NBER may not declare a recession during two quarters of very slight negative growth, choosing instead to declare an economic stagnation. However, the NBER does not precisely define what is meant by “a significant decline.” Rather, the NBER determines if one has existed on a case-by-case basis after examining their cataloged factors, which have no defined grade scale or weighting factors.

Despite the shorthand, two straight quarters of negative GDP have not always been determinative of an impending recession designation. As the NBER itself has stated, “Most of the recessions identified by our procedures do consist of two or more consecutive quarters of declining real GDP, but not all of them.”

In the 2020 pandemic-induced recession, the NBER announced the recession in June 2020 — even before the announcement of a second-straight, very negative quarter the following month.

The recession before that—the “Great Recession” between late 2007 and 2009—was also declared without two straight negative quarters registering. The designation came in December 2008, after data showed the first and third quarters of 2008 were negative, but not the second. The following month, the fourth quarter report gave us a second straight negative quarter.

And the recession before that—in 2001—didn’t satisfy the shorthand at any point. The third quarter of that year was reported as being negative, but it would be the only one, but the other quarters were not. The NBER still declared a recession in November 2001.

Will the Fed Trigger a Recession?

Even though headwinds for headline inflation are building, the metric that the Fed pays most attention, as noted, is the core Personal Consumption Expenditures (PCE) inflation index. The current 4.6% year-over-year increase is fortunately down from the February peak of 5.3%,and only 0.1% month-over-month but it’s uncomfortably above both the 1.9% rate at the start of the pandemic and the Fed’s flexible target of 2%. The persistent difficulty throughout the pandemic for the Fed has been navigating an inflation environment that is increasingly driven by supply-side factors.

To be sure, demand-driven components have borne responsibility due to monetary and fiscal policy were incredibly accommodative at the start of the pandemic; but ripple effects from the pandemic and war in Europe have exacerbated price pressures to the upside throughout the world. As such, demand- and supply-driven contributions to core PCE have been nearly equal.

While the Fed has openly admitted to its inability to rein in supply-driven inflation, it has acted swiftly and aggressively to tamp down demand, evidenced by the policy rate increases this year (and the prospect of further tightening).

The light at the end of the inflation tunnel may be visible, but the key moving forward is less about the timing of the peak and more about the level at which inflation ultimately settles. If it stays elevated and takes longer to cool—which will grow more likely if core services (the stickier component) climbs higher—that will help push the Fed to keep its foot on the brakes.

Two schools of thought had appeared regarding the Fed Funds outlook. The first one emphasized the need to front-load rate hikes and move aggressively in the process. Once that goal is attained, the Fed could pivot to rate cuts later in 2023. After Powell spoke at the Jackson Hole Economic Symposium, this school of thought was debunked.

The second can be described as “raise and hold.” This line of reasoning agrees with the front-loading approach and with moving the Fed Funds target range into restrictive territory. However, the main difference is that rate hikes would not be so aggressive as to require reversal in relatively short order. Rather, once Fed Funds reach a level deemed acceptable to tamp down inflation, the Fed would go on hold with the target range staying put for a while, perhaps for all of 2023.

The markets seem to have assimilated the hike. There are three meetings left this year for the Federal Open Market Committee, the branch of the Federal Reserve System that determines the direction of monetary policy. The next FOMC meeting is on September 21.

While Fed chair Jerome Powell stated the agency would offer less “clear guidance” on rate moves going forward, in his August 26 keynote speech at the annual global central banking conference in Jackson Hole, Wyoming, he delivered a clear message that the central bank was unequivocally committed to a restrictive policy to rein in inflation.

However, Powell did not offer any indication whether the Fed’s back-to-back rate hikes of 75 basis points each would be repeated at the September FOMC meeting. Powell did say the agency is committed to bringing inflation down to its 2% goal, which means interest rates will continue to rise, but how much it rises will depend on incoming data.

“While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses,” Powell said, an indication that the Fed would tolerate a weaker labor market to constrict consumer demand as households conserve cash in anticipation of potential job loss.

While the strong jobs report has likely given the Fed sufficient reason to maintain a hawkish stance in the near term, it is worth noting that a Consumer Price Index and Producer Price print, a retail sales print  and another jobs report will be released between now and the next rate decision (barring any inter-meeting surprises). As such, July’s strong wage growth and further evidence of labor market tightness might prove to be stale if inflation starts to ease and payrolls show some weakness in August, a month notorious for revisions.

Conclusion: Silver Linings

Inflation expectations have appeared to roll over, dispelling the notion that individuals expect higher prices to persist for several years. The market is indicating that it doesn’t expect today’s sky-high inflation to last long into the future. (That gives the Fed some cover, but hardly enough to halt rate hikes in the near term.)

Assessing each inflation and jobs report has gotten increasingly difficult given the Fed’s relatively new practice of making meeting-by-meeting decisions on policy.

This new Fed practice reinforces the fact that investors should focus more on the big picture for policy. The direction of the labor market will be key in determining the future state of the economy. Decreases in consumption come first. If businesses can’t sell as much as they used to because consumers aren’t buying as much, then they lay off workers. However, there are twice the number of job openings as unemployed workers, so employers may not be quick to lay people off. That is the path to a soft landing.