The Economy: Recession? Or a Near Miss?

FTR Expert Steve Graham takes a look at how close we are to a recession and whether we could avoid it entirely.

The Federal Reserve sent a warning shot to financial markets, consumers, and the business community late last year that the inevitable tightening of monetary policy was about to start. The economy was moving at a blistering pace, finishing the quarter at a 6.9% annual pace. Inflation was running well above target, with the PCE deflator increasing 4.4% in the final quarter of 2021. Criticism was already mounting on the Fed to start moving. Some economists thought the Fed was behind the curve. The Fed planned to guide the massive U.S. economy back to a lower altitude to cool economic growth and lower inflation. The first quarter started a trend of surprises that are continuing through the middle of 2022. The first surprise of the year was the invasion of Ukraine by Russia, a move that sent the price of oil, food, and inflation skywards. The Fed made its first move in March, and to keep financial markets calm, the first move was small, with only a quarter-point move. They did warn of more and bigger future interest rate increases forthcoming.

The second surprise of the year was the composition of the first quarter GDP, which came in negative. Economies in transition do often emit contradictory indicators. This is happening now, with some economic reports coming in positive and others negative. The consumer sector slowed more than expected, only rising 1.8%, but business investment jumped 10%. The big reason GDP went negative was inventories and their relationship to final sales. Both indicators came in negative. Inventories have been a curse on economists for a long time. You might know how many inventories are in your office and your industry, but there is no good way to know and forecast total U.S. inventory movements in real-time. Economists can tell you whether you need to add or drawdown based on historical trends, but the exact timing is difficult to pinpoint. The big surprise from the first quarter was the economy went negative well before anybody expected.

At the time of this writing, the second quarter GDP has not yet been released. There could be surprises, but the overall trends will not change. We do have monthly data that gives us insight. We were an economy that was flying well above capacity last year but is now downshifting to a lower gear. Estimates of the second quarter range widely among forecasters. The release of actual second quarter GDP data will reveal parts of the mystery. If it comes in negative, then we are in a “technical recession” and that will be up to the National Bureau of Economic Research (NBER) to decide. If GDP comes in positive, I doubt we are in recession at the current time but that does not mean we are not in harm’s way. FTR has developed an alternative forecast that shows a recession starting in the final quarter of 2022, lasting two-quarters of negative growth. Wells Fargo’s economic forecast projects real GDP will turn negative in the first quarter of 2023 and last three-quarters of negative growth. Other analysts are following similar lines. Because of the relative strength of the consumer, most forecasters are projecting a relatively mild downturn. When actual Q2 GDP numbers come out, there will be upgrades to projections.

The economy’s course will depend on inflation. The latest June numbers from the CPI and PPI were disappointing. The CPI increased 1.3% for the month and was up 9.1% year-over-year. The components of the index showed a widening of price increases across the economy. Excluding food and energy, the core index still advanced 0.7%, a robust rate. The PPI for final demand increased 1.1% in June, following an advance of 0.9% in May. Final demand prices moved up 11.3% in the last 12 months, the largest increase since the 11.6% advance in March. Like many reports concerning the economy, there are contradictory reports. Some reports suggest that inflation peaked in June and that weakness is settling in. High-interest rates usually mean a strong dollar and oil is traded in dollars. Early last week, the dollar index climbed to the highest since October 2002. U.S. demand for gasoline, jet fuel, and diesel fuel are down 10% compared to 2019. Gasoline stations have responded by lowering prices. In the U.S., prices have dropped in 46 states, with some of the biggest decreases in the Midwest, where gasoline prices have dropped more than 50 cents per gallon. Other commodities are also losing price strength. Copper is at $3.29, down 25% m/m and 25% y/y. China is having economic problems associated with COVID and that country accounts for half of the world’s usage of industrial metals.

Total retail sales jumped 1% in June after declining 0.1% in May. Excluding gasoline, where the price jumped significantly in June, sales advanced 0.7%. Since most components of retail sales are expressed in nominal terms, subtracting the CPI numbers from the retail sales figures, means spending was negative in June. The jobs report delivered a surprise to the upside. The robust addition of 372,000 was well above the consensus estimate of 250,000. The headline number is not consistent with an economic downturn. The average gain in employment in the last three months was 375,000, also not a number consistent with economic weakness. The labor participation rate came in weaker than expected, suggesting that there are still plenty of people, to bring in from the sidelines to create jobs.

The consumer is losing power and that means they are getting less stuff and paying more. That fact is showing up in the manufacturing sector. Total industrial production moved down 0.2% in June. Manufacturing output declined 0.5% for a second consecutive month. Factory orders increased 1.6% in May, but the ISM manufacturing index fell 3.1 percentage points to 53% in June, a continuation of contradictory reports that we have seen recently. The divergence between the reports shows the impact of economic crosswinds impacting the economy. Moderation in the factory usually means a broader moderation in general demand to the Fed. That means the Fed’s actions are having the intended effect. Fresh data on inflationary expectations slid to the lowest level in a year, which should take some heat off the Fed.