recessionary outlook:assessing the likelihood


June 23, 2023

While the Federal Reserve Board (Fed) chose to skip another rate hike at its June meeting, it signaled that it may increase rates later in 2023. Its June decision came after 10 consecutive rate hikes starting March 2022, with the upper bound of its target rate now 5.25%. This hiatus should be of relief to consumers who are seeking mortgages or car loans or are paying credit card bills.

However, half of the Fed’s voting members projected that the target rate will rise to 5.75% by December. Thus, the Fed’s rapid—and potentially continued—rate increases have raised the threat of a Fed-induced recession within a year.

In this report, The Mather Group, LLC (TMG) shares its outlook for a potential recession, major factors that could cause it, and links among those factors. Recessions often need a chain of adverse events to occur—not just one, such as Fed tightening.

Other factors that could contribute to a recession are changes in bank credit, consumer spending, consumer confidence, unemployment, wage gains, and stock market performance. Economic shocks such as wars, oil embargoes, and global pandemics are unforecastable, and so are not included in this report.

Fed Interest Rate Policy

The historic link between Fed interest rate increases and potential recessions is evidenced through a credit market event known as “yield curve inversion.” Normally, due to increased financial risk when funds are invested for extended periods, investors demand a higher return. So, the yield curve going from short-term (91-day Treasury bills) to longer-term (30-year Treasury bonds) assets is usually upward sloping. However, when investors believe that a recession may be on the horizon, the yield for short-term assets begins to rise above longer-term yields. This is described as a yield curve inversion, as the yield curve now slopes downward.

Why would an inversion suggest a looming recession? As shown in the graphic below, each time the yield curve has inverted since 1989 due to Fed rate hikes, a recession has resulted. Inversion occurs when the yield difference drops below 0.0%, with recessions shown as gray bars. With a current value of -1.75%, the inverted yield curve is now at its lowest rate in the last 34 years.

So, this interest rate factor suggests that a recession may occur.

Bank Credit

As shown in the graphic below, a decline in the growth of commercial bank credit during the last 34 years often preceded a recession. An explanation is that when the Fed raises rates, the demand for credit falls due to tighter bank lending standards and increased caution among businesses seeking loans. At the outset of 2022, bank lending grew at an annual rate of 10%, but with Fed tightening beginning March 2022, its annual growth rate has declined rapidly to just 2%.

So, this bank credit factor also suggests that a recession may occur.

Consumer Spending

Personal consumption represents about 70% of our gross domestic product (GDP). As shown in the graphic below, the pandemic introduced enormous volatility in the annual growth rate of consumer spending. Prior to the pandemic, in February 2020, the annual growth rate was 4.8%. It rose to 30.0% in April 2021 due to pandemic stimulus programs, but because these programs have ended, the annual rate has descended for two years toward its current level of 6.7%.

One reason for this decline, according to Bureau of Economic Analysis (BEA) studies, is that consumers accumulated $2.1 trillion of “excess” savings due to pandemic stimulus payments. The BEA estimates that only $600 billion of these savings remain, so, when combined with continuing inflationary pressures, the annual spending rate could decline further to more historic levels.

So, this consumer spending factor suggests that a recession may not occur.

Consumer Confidence

Of course, consumer spending is linked strongly to consumer confidence. In turn, confidence is driven by multiple forces and is often volatile. Prior to the pandemic, confidence remained relatively level, but then dropped precipitously with the pandemic’s arrival. It then rose with the inflow of pandemic stimulus funds but dropped to its recent low of 50.6 in June 2022. It then rose steadily for 12 months to a level of 63.9 in June 2023.

So, this consumer confidence factor also suggests that a recession may not occur.

Unemployment Rate and Wage Gains

If consumer sentiment helps drive consumer spending, so does being employed and receiving salary increases. As shown in the graphic below, both factors suggest increased labor force resiliency as the pandemic subsided. After reaching an unemployment rate of 14.7% in April 2020, the level has declined significantly to 3.7% in April 2023.

This level is concerning to the Fed, which believes the non-accelerating inflation rate of unemployment (NAIRU) should range between 4.5% - 5.5%. Unemployment rates below the NAIRU are deemed to be inflationary and to restrict GDP growth due to worker shortages.