[Contribution] Can the US economy avoid a recession?

Consumption, income, employment unlikely to trigger recession

Stephen Lee is the chief economist at Meritz Securities / Courtesy of Meritz Securities

By Stephen Lee

Controversies have heightened recently over whether the U.S. economy will run into another recession or not. Most forecasters likely have penciled in a mild recession during 2023. Real GDP growth forecasts for this year have been revised down significantly, especially during 4Q22.

The most recent consensus compiled by Bloomberg, anticipates that the U.S. economy will grow 0.5 percent for the full year, but quarterly GDP will contract a respective 0.6 percent and 0.3 percent quarter-on-quarter (annualized) during the second and third quarters of 2023. Note that this number is a median of more than 30 forecasts. Goldman Sachs, Morgan Stanley and Credit Suisse ― those well known to Korean investors anticipate that the U.S. economy will be able to weather the recession during this year and next, contrary to the consensus.

Why many believe another recession is imminent

Nevertheless, recession fears themselves look completely reasonable, given the movements of early warning signals. The New York Fed calculates recession probability based on the U.S. treasury yield spread between the 10-year and 3-month tenors. The spread has started to narrow in July 2022, and eventually inverted in November. The spread was -74 basis points by December last year, implying a whopping 47.3 percent likelihood of recession probability within the next 12 months.

Another indicator is the Conference Board's leading economic index. The Conference Board itself regards it as a recession signal, if the index falls below -4 percent on a 6-month annualized growth basis. By December 2022, the index was down 6.0 percent year-on-year, and 8.2 percent by 6-month annualized growth. Lastly, the ISM manufacturing survey's new order index came in at 45.2 in December 2022. When the index fell below 45, recession was inevitable in most cases.

There was an exception, however, when the U.S. economy avoided recession despite these warning signals indicating that another contraction would be with us soon. That was in 1967 when the Federal Reserve conducted a preventive rate cut for the first time in history, and eventually turned the economy around to a mild expansion. This time, however, many anticipate that a recession will happen because it will be difficult to see a rate cut move from the Fed during this year.

A look at traditional definition of recession from NBER

Some investors argue that the U.S. economy is already in recession. The argument can sound natural if we just look at the housing market. For us to gauge whether the whole economy is in a recession or not, it seems noteworthy to see how the Business Cycle Dating Committee within National Bureau of Economic Research (NBER) defines a recession.

Many of us perceive that an economy is in a recession when real GDP contracts for two consecutive quarters. This is not wrong, as GDP contains a wide range of economic activities from consumption and investments to trade. NBER's traditional definition of recession requires more than a GDP contraction: that it is a significant decline in economic activity, which is spread across the economy and that lasts more than a few months.

In gauging these economic activities, NBER monitors eight indicators. These are 1) all nonfarm employees (establishment survey within BLS employment statistics), 2) household employment, 3) industrial production, 4) real manufacturing and trade industries sales, 5) real personal income (excluding current transfer payments), 6) real personal consumption expenditures, 7) real GDP, and 8) real GDI (Gross Domestic Income).

Historically, we note that NBER has defined the economy as a recession when more than six of these eight indicators contracted quarter-on-quarter, and lasted for more than a few months. If we look at 4Q22, all indicators except industrial production likely have grown during the period, given the real GDP estimate for the quarter stands at 2.0 percent (annualized), and real GDI moving in sync with real personal income. Recession is not here yet, only there are possibilities that it may come in the near future.

The next possible candidates, in my view, seem to be real manufacturing and trade sales and real GDP. The latter may contract given the steep correction on the investment side from both residential and non-residential. Just like what we have learned from the textbooks, a rise in the real interest rate definitely is affecting real investment these days. However, even considering these two, it's just three out of eight. Therefore, in order for the wide range of indicators to imply recession, consumption, income and employment should contract going forward.

Consumption, income and employment indices are determinants

Let us look at consumption first. Since the COVID-19 outbreak, real consumption expenditure growth has consistently topped that of real personal income (excluding transfer payments). This is unusual, given households face budget constraints and these caps were generally labor income. Households spending more than what they've earned means that there were other sources of spending. These excess savings, stem from the massive stimulus during 2020-21, and have likely acted as a source.

How much excess savings accumulated and how much has been spent is an area of estimation. Assuming savings beyond pre-COVID trends is all excess savings, it is estimated that these accumulative savings once rose to $2.2 trillion in mid-2021. As inflation eroded household purchasing power, the amount dropped to $1.3 trillion by November 2022. Some say that these excess savings will be depleted this year and push people towards a consumption cliff. I believe that if the past six-month trend of $80 billion depletion per month continues, consumption buffers will remain in positive territory this year.

Moreover, real income growth has resumed in 2H22, as inflation growth peaks out and wage growth is stickier than that of inflation. In a period of no excess savings, people can spend within their real income, which becomes greater than the previous months. Therefore, I believe any woes of a consumption cliff will not be realized.

Employment is also unlikely to shrink, given the structural tightness of the labor market. If employers thought economic activity is about to shrink, job openings are likely to have declined very steeply. According to the high-frequency job postings index by Indeed.com, the index was at 144.1 as of Jan 20, 2023 (Feb 1, 2020=100). The index was at 149.2 by the end-of 2022, implying a mere 3.5 percent decline since the beginning of this year.

That said, such a mild decrease does not imply that employment will shrink. Given the job vacancies-to-unemployment ratio for January, which is estimated at near 1.6x this month, the labor market is still tight and has not overcome the structural shortages created by early retirement, the decrease in immigration and deaths from COVID-19.

It is worth keeping in mind that there is around a 3.5 million shortfall in the labor force, compared to the estimate done by the Congressional Budget Office in January 2020 (pre-COVID). I believe employers will still struggle to secure employees, while layoffs are likely to be common stories in tech and platform businesses facing significant profit growth slowdowns and restructuring needs.

One other indicator that I am keenly monitoring is the Hiring Plans Index from the National Federation of Individual Businesses (NFIB) survey. It stands at 17 as of December 2022, and is far from near-zero or negative, which we saw during typical recessionary episodes in the past.

Economic activities in the U.S. as well as those indicators on these activities are deteriorating. The numbers we will get to see will create further recessionary fears in the coming months. Still, in my view, this downturn is likely to be concentrated in investment areas, while income, consumption and employment will hold up. Rather than saying that a recession is coming, I would choose to stay in the camp, which insists that the U.S. economy will avoid recession by a narrow margin.

The writer is the chief economist at Meritz Securities.