Why The Recession Is Always Just Around The Corner

The effort to contain inflation by Federal Reserve Chairman Jerome Powell is becoming more difficult as consumer spending and hiring remain robust.

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The next economic slump is now the one that Americans are most looking forward to in recent memory. Also, it keeps getting put off.

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The Federal Reserve's efforts to control inflation are being hampered by the pandemic and the unusual policy measures that followed, according to the most recent strong hiring and consumer spending data.

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The government's stimulus initiatives have resulted in unusually healthy household and business finances. Companies still struggle to meet demand for rate-sensitive commodities like homes and cars because of a lack of employees and supplies. Also, Americans are now spending money on labor-intensive things like traveling, live entertainment, and eating out, which they had previously shunned.

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In general, Wall Street economists predicted a recession by the middle of 2023 as a result of the Fed's swift interest rate rises. Some people still think it's possible. Many now believe that it will take longer for the economy to cool, which will force the central bank to raise rates more than anticipated.

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The "Godot" recession, according to Ray Farris, head of economic research at Credit Suisse. Last October, Mr. Farris was one of a small group of economists who forecast the economy would just avoid a downturn this year. Every six months, he added, economists have foretold a recession that will occur six months later. They will still be anticipating a recession in six months by the middle of the year.

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In an effort to battle inflation, the Fed has been rising interest rates, which makes borrowing more expensive and may cause the price of assets like stocks and real estate to decline. Officials raised the benchmark federal-funds rate more over the past 12 months than at any time since the early 1980s after keeping it close to zero during and after the pandemic, most recently to between 4.5% and 4.75% last month.

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The recent improvement in the economy will cause Fed officials to put off thinking about when to stop raising interest rates. Instead, investors are searching for hints as to whether they will raise rates by a half-point in March 21-22, like they did in December, or a quarter-point as they did last month.

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Tuesday marks the start of two days of congressional testimony by Fed Chair Jerome Powell, during which he will have the chance to discuss the most likely course of action for the central bank in the event of a more resilient economy. Most Fed officials predicted in December that rates would increase this year to between 5% and 5.5%, and officials have suggested those predictions could increase at their upcoming meeting.

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The economy is still bizarre.

The distinctive character of the current economic recovery is illustrated by three elements.

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First off, following the initial shock of Covid-19 in March 2020, Washington responded by keeping interest rates at extremely low levels and flooding the economy with cash, which left the finances of households, businesses, and local governments in extraordinarily good shape.

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According to estimates by Fed analysts, until last June, U.S. families had about $1.7 trillion more in savings stockpiled through mid-2021 than if income and expenditure had increased in step with the prepandemic economy. Money can still flow through the economy even after it has been spent; after all, one person's expenditure is also another person's source of income.

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Peter Berezin, chief global strategist at BCA Research in Montreal, stated that we are currently experiencing the second, third, and fourth round consequences of the initial savings sparked by all of these transfer payments during the pandemic. When expansions are driven by credit growth rather than incomes and stimulus, the main forces behind the post-pandemic recovery, rate increases may have a more immediate negative impact on the economy.

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As interest rates reached new lows in 2020 and 2021, businesses were able to lock in cheaper borrowing costs. According to Goldman Sachs, only 8% of junk bonds, or those issued by corporations without investment-grade ratings, mature over the next two years.

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Second, the rate-sensitive housing and car markets are currently more resistant to increasing interest rates due to a lack of supplies and labor. Builders of new homes frequently use "buydowns," in which they pay to temporarily lower the buyer's mortgage rate. For-sale inventories are at historically low levels as a result of the fact that many present owners are reluctant to sell because doing so would require them to accept a considerably lower rate.

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The demand for homes and automobiles typically declines when the Fed rises interest rates, forcing builders and automakers to reduce output and lay off people. Companies are still catching up this time around.

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Despite a substantial decline in home sales, employment in the construction industry has not decreased. Builders are still finishing the residences and apartments they began before to the Fed's rise in borrowing rates. Construction completion times have increased due to supply-chain delays. In addition, apartment construction increased significantly following the epidemic, and these projects take longer to complete.

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Since stocks of new automobiles were kept at extremely low levels due to semiconductor chip shortages, prominent brands of fuel-efficient cars are now benefiting from pent-up demand.

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According to Eric Rosengren, who served as the Federal Reserve Bank of Boston's president from 2007 to 2021, this might make the typical rate-induced slowdown in the auto and housing markets more gradual. To bring supply and demand back into balance, "it may take higher interest rates or higher interest rates for a longer period."

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Lastly, American consumers have increased spending on services that employ many people, such as dining out and tourism, after abandoning their epidemic caution. This is another instance of pent-up demand interfering with the regular business and interest-rate cycle.

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When consumers fear losing their jobs, such industries are frequently among the first to experience a decline in demand and employment losses. Stopping to dine out and taking holidays is the simplest method for households to cut costs.

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Lower fuel costs and an additional boost in January from larger Social Security checks—which are inflation-indexed—have also contributed to a recent uptick in consumer spending. Following Russia's invasion of Ukraine, gas prices increased last spring. According to economists at Morgan Stanley, they then gradually decreased over the second half of last year, alleviating a cash crisis for some consumers that may have offset increased rates on mortgages, credit card balances, and vehicle loans.

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Goldman Sachs economists said on Sunday that if consumer spending exceeds forecasts, the Fed may decide to raise rates to just below 6% this year. This might prolong a run of rate increases by a quarter point into September.

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Labor Market Puzzle

The main source of Mr. Powell's concerns about inflation is the labor market. This is due to the fact that consistent income growth will maintain consumer purchasing power and permit businesses to maintain price increases.

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The fact that longer-dated bond yields resolutely refused to grow while the Fed raised rates in the 2000s was described as a paradox by then-Fed Chairman Alan Greenspan. The labor market's strength is Mr. Powell's interpretation of the paradox. Companies continue to hire new employees and retain existing ones, delaying the onset of recessions.

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While forecasters were expecting a downturn, employers created 517,000 new jobs in January, lowering the unemployment rate to 3.4%, the lowest level in 53 years. Previous reports that were revised indicated less weakness than originally believed.

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When the Labor Department releases its report on February hiring on Friday, it will be possible to determine if January's hiring was an exception or an indication of an expanding economy. A other data being out on Wednesday might reveal whether workers are still quitting their jobs at historically high rates, which can be a sign that they have more faith in their potential to land better-paying employment.

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According to economists at Morgan Stanley, personnel levels in the United States are still marginally below what they would have been in the absence of the pandemic. This year, they anticipate that gap to close, which would cause hiring rates to decline.

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M. Robert Half International Inc. CEO Keith Waddell drew attention to a discrepancy between a robust labor market and corporate surveys showing signs of waning demand for workers. In spite of that, he noted on a Jan. 26 earnings call that orders had not stopped coming in. "Just getting them closed takes longer. Less urgent are our customers. They are moving faster now. More candidates are desired.

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Officials at the Fed are racing to halt the economy before inflation takes hold. However, they are attempting to avoid hiking rates too much and provoking unneeded economic hardship.

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Given that they had up until a year ago adopted such extremely stimulative policies, some Fed officials assert that it may take some time to observe the results of their actions. Raphael Bostic, president of the Atlanta Fed, said last week that "there is a credible argument to imply that we're going to see" further slowing to come because interest rates have only lately reached levels that could be viewed as restrictive.

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According to Mr. Bostic, business owners express confidence in their individual prospects but worry about the overall economic climate. The shoe will eventually drop, but everyone is waiting for it to fall on someone else, he claimed.

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A Desire For Speed

Because of Mr. Powell's swift increase in interest rates, it is unclear when and how much the economy will slow. In the past, the Fed has spread out rate rises, for example, from 2004 to 2006 and from 2015 to 2018, when lower inflation permitted policymakers to proceed more slowly.

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According to Kristin Forbes, a professor at the Massachusetts Institute of Technology and a former member of the Bank of England's monetary policy committee, the strategy appeared to be effective because it kept businesses and households from anticipating higher future inflation, which would have set off a destabilizing price spiral. The disadvantages of that tactic are now becoming clear.

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It is more difficult to determine whether you need to wait a bit longer to see the consequences or whether the economy is simply more resilient if you front-load hikes, she added.

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In order to have more time to analyze the results of their prior actions, officials delayed the rate of rises in December and once again last month. Mr. Rosengren believes the slower rate-rise path is acceptable despite reports of faster growth and inflation over the previous month. You still need to know when the prior tightenings will start to make a bigger difference, he said. The likelihood of a recession "remains pretty strong, but the time is tough to estimate," he said.

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Since October, the Fed has had to contend with the problem of bond investors starting to believe that inflation would decline swiftly without a significant downturn. They therefore predicted that the Fed would lower rates more quickly than official statements from the central bank indicated.

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That put the Fed at risk of an unfavorable feedback loop. While the central bank regulates short-term rates, long-term rates are determined by broader market conditions. Between October and February, long-term rates moved lower, which reduced borrowing costs slightly. The 30-year fixed rate mortgage dropped from 7% last fall to roughly 6% today.

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This has produced a paradoxical chain of events whereby long-term rates are being held down due to predictions that the economy will contract, which can boost activity and prevent the economy from contracting.

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Since then, long-term Treasury yields have increased as investors have grown increasingly anxious about inflation and lost faith in the Fed's ability to decrease interest rates soon. Whether the rise in yields will be sufficient to put the economy in the slower gear the Fed wants is a major unknown.

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In order to decelerate the economy, the Fed must raise long-term yields, according to Mr. Berezin. "A recession won't happen until more people are sure there won't be one,"

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