US: Technical recession

In recent weeks we highlighted the Atlanta Fed’s GDPNow-cast indicating negative GDP growth in Q2, which would imply that the US is in a ‘technical recession’. Yesterday, the Atlanta Fed updated its nowcast for Q2 to -1.2%. Today, the Bureau of Economic Analysis (BEA) published an advance estimate for Q2 GDP growth of -0.9%. This means that the US economy has been in a ‘technical recession’ in the first half of the year.

However, there are doubts about the reliability of the GDP figure for the first quarter because it differs so much from the GDI number. (The advance estimate does not yet provide an estimate of Q2 GDI). In theory, GDP and GDI should be equal, because they measure the same. In practice, there can be considerable statistical discrepancies. While GDP showed negative growth in Q1 and Q2, GDI growth remained positive in Q1. This means that the ‘technical recession’ could be a measurement error.

What’s more, in the US, recessions are officially dated by the National Bureau of Economic Research (NBER), which takes a broader look at economic data and is not likely to declare a recession in the first half of 2022 when unemployment has been stable at 3.6% in the last four months and nonfarm payroll growth has been above 350K in each month of H1. Therefore, it looks like the US is not in an official recession yet. However, we expect that this is only a matter of time.

Today’s GDP report showed that the US economy has had two consecutive quarters of negative GDP growth, which means a ‘technical recession’ in the first half of this year. After -1.6% growth in the first quarter, the advance estimate for the second quarter is -0.9%. While the contraction of GDP in Q1 was largely caused by net exports (more than 3 ppt contributed), inventories contributed more than 2 ppt to the GDP decline in Q2. However, while personal consumption and business investment grew at a decent pace in Q1, personal consumption slowed down considerably in Q2, business investment came to a standstill, and residential investment saw a steep decline. In other words, domestic demand showed a major slowdown in Q2. This suggests that underlying momentum in the economy is fading and it is only a matter of time before businesses slow down hiring. At the moment, they are still hiring at a high pace to keep up with excess demand for goods and services, but if this comes down, we are going to see a slowdown in employment growth as well. Eventually, when employment growth turns negative and the unemployment rate rises, the NBER will declare an official recession.

Not only the employment growth figures tell a different story than GDP, within the national accounts the GDI data fit better with the picture that the nonfarm payrolls are painting than with GDP. While GDP showed -1.6% growth in Q1, GDI grew by +1.8%. (The advance estimate for Q2 does not yet include GDI.) In theory, GDP and GDI should be equal. They both measure output, but GDP measures the value added of goods and services produced while GDI measures the income earned in this production (such as wages, profits, interest income, rental income). However, in practice there are “statistical discrepancies” than can be very large, such as in Q1. Although GDI and GDP both suggest that economic growth in Q1 was weaker than in Q4, the slowdown according to GDI was not as severe as GDP indicates and does not point to a contraction. The BEA says that it considers GDP a more reliable measure because it is based on timelier and more expansive data. However, others point out that GDI is more reliable because its revisions are less volatile. At present, GDI seems to be more in line with the robust labor market data than GDP.

In textbooks on macroeconomics, a recession is usually defined as two consecutive quarters of negative GDP growth. However, in the US, recessions are officially dated by the NBER. Their definition emphasizes that “a recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months.” Relatively vague, but in practice nonfarm payroll growth and growth in real personal income less transfers have been more important than GDP growth. The latter can turn negative despite strong private domestic final demand as we saw in the first quarter of this year.

While GDP growth has been negative in Q1 and Q2, employment has grown at a strong pace of more than 350K per month. Consequently, unemployment remained steady at 3.6% in the last four months. This does not fit with “a significant decline in economic activity across the economy.” Therefore, the current data are not likely to give the NBER reason to date a recession in the first half of 2022.

While technically the US is already in a recession, we think the official NBER-dated recession is only a matter of time. As we explained in The inevitable recession, the timing of the recession depends on whether the exogenous supply shocks and resulting inflation are going to push the economy into recession or whether it will be the Fed’s monetary policy tightening that pushes the economy over the edge.

Note that we do not hold the Fed solely responsible for the recession in our baseline forecast (2023H2). The current damage to the US economy is largely caused by a series of negative supply shocks. The resulting inflation has diminished the purchasing power of consumers and has led to higher input costs for producers. On their own, these supply shocks and inflation could already push the economy into an NBER-approved recession before the Fed has ended its hiking cycle.

However, if we reach the end of the year without a recession, the monetary policy tightening on top of these supply shocks is likely to ensure a recession, unless a soft landing is achieved. But since monetary policy is a blunt instrument that also works with long and variable lags, getting it right seems highly unlikely. Especially for a central bank that has been wrong and too slow to react since inflation started to rise last year. Powell has already admitted that a soft landing may be dependent on factors outside of the Fed’s control, such as possible new supply shocks. What’s more, the wage-price spiral forces the Fed to engineer a recession, unless a path is found that reduces wage pressures without causing a recession. The Fed has tried to put forward a scenario in which it would reduce vacancies without substantially raising unemployment. As we have said repeatedly, this approach requires active labor market policies, which are outside the scope of the Fed, and rather the prerogative of federal, state and local governments. That is why we say the recession is inevitable: either the negative supply shocks cause a recession, or the Fed’s attempt to terminate the wage-price spiral will do the job.

While negative supply shocks and inflation have done most of the damage to the economy so far, the hiking cycle is already working its way through the economy. While the Fed started raising policy rates only four months ago, and the target range was raised to about neutral only this week, longer-term rates have already risen substantially. Treasury yields (10 year and 30 year) have returned to their peaks of the previous hiking cycle, and 30-year mortgage rates have even risen to levels we have not seen since 2008. Even in real terms, mortgage rates are higher than in the last decade. This is reducing the affordability of homes, only four months into the Fed’s hiking cycle. This shows how expectations of future policy rate hikes are already finding their way into the economy. Consequently, on top of negative supply shocks and high inflation, households and businesses are now also dealing with much higher interest rates than the current federal funds rate suggests. This has led to a 14.0% contraction in residential investment in Q2 that has contributed to a technical recession in the first half of the year.

Negative supply shocks, inflation, and the early impact of the Fed’s (anticipated) hiking cycle on mortgage rates have already caused a ‘technical recession’, i.e. two consecutive quarters of negative GDP growth. However, the type of recession that will squeeze inflation out of the US economy is the one that meets the NBER standards, including a decline in employment and a rise in the unemployment rate. The latter will terminate (or prevent in the eyes of the Fed) the wage-price spiral. As long as nonfarm payroll growth remains strong, the NBER is not likely to declare an official recession. Fed Chair Powell also said yesterday that he does not think this is a recession. Nevertheless, the economy is getting slowed down by the series of supply shocks, inflation and tighter monetary policy. So an NBER-approved recession is only a matter of time. Ironically, we need one to get inflation out of the system.