What Does A Recession Look Like?
What necessary ingredients do we need to bake up a recession? The National Bureau of Economic Research (NBER) looks for economic declines that are significant, broad-based, and persistent. Or, to use the terminology of the NBER business cycle dating committee, the three criteria are “depth, diffusion, and duration.”
Because the committee looks at a broad swath of the economy, the important metrics cover the labor market, consumer income and spending, and industrial production. A recession is when these broad-based parts of the economy experience a significant and persistent downturn.
Are We in One or Not?
We are currently not in a recession. At least not yet. Consumer spending was too strong in Q2 to satisfy the requirements of a significant, broad-based, and persistent contraction. “Although we are probably not in a recession, risks are rising. One ominous sign is rising unemployment claims,” warned Jeffrey Roach, Chief Economist at LPL Financial.
As shown in the LPL Chart of the day, Q2 GDP fell an annualized -0.9%, quarter-over-quarter. However, consumer spending on services grew in Q2, contributing to headline economic activity for the 8th consecutive quarter. Inventory rebuilding is one of the most volatile activities in the economy and is sometimes a wildcard in forecasting. Although the U.S. has now experienced two consecutive quarters of negative growth, investors should remember that recessions do not always correlate with headline GDP data. For example, in 2001, the U.S. had a recession yet growth was 2.5% in the second quarter.
Higher interest rates are weighing heavily on business investment. Declines in general business capital spending reveals a budding weakness in the corporate sector of the economy and could be an ominous sign. Another disconcerting sign in the economy is the weekly claims for unemployment insurance benefits. Initial unemployment claims are trending upward, a more ominous sign than the negative Q2 GDP report. After yesterday’s update, the 4-week moving average of initial claims is up to 249,000. The low point was 171,000 in April. Rising claims indicate a weakening labor market.
What Can the Federal Reserve Do?
Committee members are increasingly concerned about weakness in consumer spending and manufacturing. In recent months, the one bright spot was the labor market as job gains were solid. However, as businesses increase layoffs to cut costs, the job market will likely cool in the latter half of this year, complicating things for central bankers.
As long as inflation pressures remain, the Fed will feel compelled to continue tightening financial conditions. Therefore, The FOMC could raise the target rate another 1% by the end of the year but that is predicated on a solid job market, which is not a guarantee as businesses have recently increased layoff announcements.
The best scenario investors can hope for is like the mid 1990s. The economy escaped recession as the Fed pivoted from increasing rates to cutting rates when labor markets weakened.
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