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Why the US Will Enter a «Technical Recession»

02 AUGUST, 2022
AER Public Insights
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Global economic cycles, both upward and downward, are usually generated in the United States. It is therefore relevant to analyze whether the country will enter a recession, and what the policy consequences might be. Household consumption has already entered negative territory.

The great Swedish economist Knut Wicksell wrote in 1898: "Changes in price levels always arouse great interest. Obscure in their origin, they have a profound and lasting influence on the whole of a country's society and economy". The US economy is the largest in the world, with some $23 trillion in output, followed by China, with some $18 trillion, and the Euro Zone, with about $14 trillion. The second is currently being threatened by an acute real estate crisis.

As global economic and financial cycles, both upward and downward, are often generated in the US, it is relevant to analyze whether the US economy will enter a recession. In my opinion, the answer is yes. Let us first discuss what a recession is, and then consider the reasons why the US will enter a recession, and finally also qualify the concept of "technical recession".

Financial markets often employ the term “recession” to refer to two consecutive quarters of economic contraction. In reality, the definition of recession can be more complex. In the specific case of the U.S., the definition of recession falls to the National Bureau of Economic Research (NBER), which certifies whether or not the economy has entered a recession by analyzing the drop in production, its intensity and other additional variables, especially unemployment. In other words, a six-month drop in production does not necessarily coincide with the NBER's subsequent classification. In turn, the International Monetary Fund (IMF) defines a recession as a fall in GDP per capita worldwide. For instance, if world GDP rises, but less than the population, then it is considered a world recession.   For simplicity, we will use the first concept of recession (two quarters of negative growth) in this article. 

The reasons why the U.S. will enter a recession are defined as follows:

First: economic contraction during the first half of the year. During the first quarter, US GDP contracted by an annualized 1.6%, and as it is very likely that the economy will also experience a contraction in the second quarter (real-time econometric indicators point to an annualized contraction of close to 2.1% during that quarter), something we will know at the end of July, we will have a recession on our hands.

Second (and related): inflation is higher than wage increases, so consumption suffers in real terms.  Consumer inflation in the US is above 8% and wages in turn are rising by between 5% and 6% depending on which indicator is used. The consequence is that real demand (net of inflation) for goods and services tends to shrink. As consumption is by far the most relevant part of GDP (final consumption expenditure accounts for about two-thirds of GDP), a fall in consumption tends to drag down the GDP indicator as well. Until now, households have weathered the inflationary storm by reducing their savings rate or by drawing on savings accumulated during the pandemic. However, the latest available data is indicating consumption has turned negative in May compared to April levels.

Third: falling inventories. The U.S. economy fluctuates depending on the accumulation or reduction of inventories by companies. Since consumer spending began to recover from the collapse of the oil crisis, demand has been concentrated in goods (such as buying an exercise bike) as opposed to services (such as paying for a gym membership). This fact explains an important part of the inflation problem in the US and the tensions in supply chains. Companies reacted to this with significant inventory buildups, which generated incremental demand for GDP through the end of 2021.  However, as the health situation stabilizes, consumers are once again demanding more services and fewer goods. The consequence is that companies are forced to liquidate excess inventories of goods, a factor that explained the drop in GDP in the first quarter and will also be observed during the second quarter. Paradoxically, this return to normalcy in the demand for services versus goods will cause inflation data to slowly ease from the second half of the year onwards through lower growth in the price of goods.

Fourth: slowdown of the real estate sector. As the Fed has signaled sharp rate hikes this year that could push rates above 3%, the benchmark mortgage rate has moved closer to 6%. The obvious consequence has been lower demand for homes. Thus, home sales fell by 9% year-on-year in May, and housing starts by 14% relative to the previous month. However, the real estate sector will not enter a crisis because supply remains limited (2 million fewer houses have been built than required to meet demand, and as a result, housing starts are up 19% year-on-year).

Why do I speak of "technical recession"? Because virtually all recessions tend to have a combination of falling GDP and rising unemployment. However, if the US goes into recession during the first half of the year due to a fall in GDP, it will not have seen a rise in unemployment (the unemployment rate was at 4% in December and is currently at 3.6%). The reason for this is the shortage of labor, as evidenced by the fact that there are more than 11 million job openings (almost two for every unemployed person). Therefore, it is feasible that the market and the press talk about "recession" while the NBER does not.  In 2001 the opposite phenomenon occurred: GDP did not fall for 6 months but the rise in unemployment caused the NBER to declare a recession. That is why I speak of "technical recession": while it may be true for the markets, it may not qualify as one for the NBER.

In addition, it is important to distinguish between a recession such as the one experienced during the great financial crisis and a technical recession. In a major recession, a housing bubble usually bursts, which affects banks and their ability to lend, leading to a sharp fall in GDP and a sharp rise in unemployment. A technical recession is something much milder, output falls, unemployment rises more slightly, and banks continue to lend. This time it will be a technical recession (the US private sector is much healthier, and the banks are better capitalized). In the last 70 years there has been only one major recession, compared to 11 technical recessions.

On the other hand, it is possible that the Fed's rate hike, which operates with lagged effects, will generate another technical recession in the coming quarters. This situation will lead the Fed to lower rates again at the beginning of 2024, something that is already beginning to be discounted by the yield curves. As an indication, in the 12 recessions experienced by the US since 1945, the economy contracted at an annualized rate of 2.5%, unemployment rose by 4% and the recession lasted just under 10 months on average. This time it is possible that the rise in unemployment will be lower, but it will nonetheless provoke a reaction from the FED. 

At Arcano Economic Research we have written reports on the detailed consequences of a technical recession in the world's leading economy. At the political level, it is possible that American voters will go for a Republican candidate in 2024, as they have done when they have experienced episodes of high inflation or economic crisis. If Trump is not impeached by the events on Capitol Hill, he is likely to be re-elected President.  Moreover, weakness in US consumption of goods will mean additional bad news for the ailing Chinese economy. In turn, Europe will grow below trend, that is, if Russia does not cut off 100% of its gas.

Wicksell, the aforementioned Swedish economist, also devised the concept of the "natural rate of interest". He defined it as that which would determine a market of savers and investors in a natural way, without the intervention of a central bank. In the medium term, the interest rates set by banks would eventually adapt to this "naturalness" (today they are called "neutral" rates). If Wicksell is right, rates will return to low levels in the medium term and a promising expansionary phase of the economy will begin in 2024.

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