How will we know if the US economy is in recession?

washington • Thursday’s government report that the economy grew 1.1% annually for the most recent quarter signaled that one of the most anticipated recessions in recent US history is yet to come. However, many economists still assume that a recession will hit as early as the current April-June quarter – or shortly thereafter.

The expansion of the economy in the first three months of the year was mainly driven by healthy consumer spending, but buyers became more cautious towards the end of the quarter. Companies are also cutting equipment spending, a trend that has continued.

The list of obstacles facing the economy keeps growing. The Federal Reserve raised its benchmark interest rate nine times last year to a 17-year high, driving up the cost of borrowing for consumers and businesses. In response, inflation has eased slowly but steadily. Nevertheless, the price increases are persistently high.

And last month, the collapse of two major banks led to a whole new threat: a fall in lending from the financial system that could weaken growth even further. A Fed report on business conditions this month found that banks are restricting lending to preserve capital, making it harder for companies to borrow and expand. Fed economists are forecasting a “mild recession” later this year.

Still, there are reasons to expect that if a recession does come, it will be comparatively mild. Many employers, who have struggled to hire new staff after massive layoffs during the pandemic, may choose to retain the bulk of their workforce even in a shrinking economy.

Six months of economic decline is a long-held, informal definition of a recession. But nothing is easy in a post-pandemic economy, where growth was negative for the first half of last year but the labor market remained resilient, with extremely low unemployment and healthy employment levels.

The direction of the economy has puzzled Fed policymakers and many private economists since growth stalled in March 2020 when COVID-19 struck and 22 million Americans were suddenly out of work.

Fed officials have made it clear that they are prepared to push the economy into recession if necessary to beat high inflation, and most economists believe them.

So what is the probability of a recession? Here are some questions and answers:

Why are many economists predicting a recession?

They expect the Fed’s aggressive rate hikes and high inflation to overwhelm consumers and businesses, forcing them to significantly curb spending and investment. Companies are also likely to have to shed jobs, leading to a further drop in spending.

Consumers have so far proved resilient in the face of higher interest rates and rising prices. Still, there are signs that their robustness is beginning to crumble.

Retail sales have fallen for two straight months. The Fed’s so-called beige book, a collection of anecdotal reports from companies across the country, shows that retailers are increasingly seeing consumers resist higher prices.

Credit card debt is also rising, evidence that Americans need to borrow more to sustain spending levels, a trend that is unlikely to be sustainable.

What would be some signs that a recession may have begun?

The clearest signal would be a steady increase in job losses and a rise in unemployment. Claudia Sahm, economist and former Fed staffer, has noted that since World War II, a half-percentage-point rise in the unemployment rate over several months has always signaled the beginning of a recession.

Many economists are watching the number of people filing for unemployment benefits each week, a measure of whether layoffs are getting worse. Weekly jobless claims have risen as a range of companies, from Facebook parent Meta to industrial conglomerate 3M and ride-sharing company Lyft, announced layoffs.

Still, employers added a solid 236,000 jobs in March and the unemployment rate fell to 3.5% from 3.6%, almost a half-century low.

Any other signs to look out for?

Economists monitor changes in interest payments, or yields, on various bonds for a recession signal known as the “inverted yield curve.” This occurs when the yield on the 10-year government bond falls below the yield on a short-term government bond such as the 3-month T-bill. That’s unusual. Typically, longer-dated bonds give investors a higher yield if they tie up their money longer.

Inverted yield curves generally mean that investors are anticipating a recession that will force the Fed to cut rates. Inverted curves often precede recessions. Still, it can take 18 to 24 months for a downturn to occur after the yield curve inverts.

Since last July, the yield on the two-year Treasury bills has exceeded the 10-year yield, suggesting that markets are anticipating a recession soon. And the three-month return has also risen well above the 10-year return, an inversion that has an even better track record of predicting recessions.

Who decides when a recession has started?

Recessions are officially declared by the obscure-sounding National Bureau of Economic Research, a group of economists whose Business Cycle Dating Committee defines a recession as “a significant decline in economic activity that is spread across the economy and lasts longer than a few months.”

The Committee considers recruitment trends. It also assesses many other data points, including income indicators, employment, inflation-adjusted spending, retail sales, and factory production. It gives high weight to a measure of inflation-adjusted income that excludes government support payments such as Social Security.

But the NBER typically doesn’t declare a recession until well after a recession has started, sometimes up to a year.

Does high inflation typically lead to a recession?

Not always. Inflation reached 4.7% in 2006 – a 15-year high at the time – without triggering a slowdown. (The ensuing 2008-2009 recession was caused by the bursting of the real estate bubble).

But if inflation gets as high as last year – it hit a 40-year high of 9.1% in June – a recession becomes increasingly likely.

There are two reasons for this. First, the Fed will raise borrowing costs sharply when inflation gets so high. Higher interest rates then pull the economy down as consumers are less able to afford homes, cars and other major purchases.

High inflation also distorts the economy itself. Consumer spending, adjusted for inflation, is weakening. And companies are becoming uncertain about the economic outlook. Many of them are withdrawing their expansion plans and are no longer hiring. This can lead to higher unemployment as some people quit their jobs and are not replaced.

Justin Scaccy

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