Easing Financial Conditions Help Reduce Headwinds To Growth
Not surprisingly, given the year ended stronger than expected and with looser financial conditions, the probability of a U.S. recession starting within the next 12 months has moderated to 26% since our last publication in September. This is slightly down from the 34% average in the third quarter of last year but twice the baseline probability of recession since World War II (13%, see chart 1).
The still elevated probability of a recession compared with normal times largely reflects the inverted yield curve (see chart 2). In the U.S., an inverted yield curve has predicted seven of the past seven recessions, with no false positives (unlike the stock market, which is well known for its false positives). A few times when the yield spread came close to inverting (for example, in 1995 and 1998), the Federal Reserve responded by preemptively cutting rates, which in hindsight appears to have helped extend the expansion.
Historically, the time between the first month of an inversion and the start of a recession has ranged from six to 18 months. However, this time may be different since this expansion is coming out of a pandemic-induced recession, rather than a more typical recession caused by the business cycle or financial markets. Moreover, the Fed’s balance sheet policy since the global financial crisis may be distorting the usual signal through compressed term premium.
The current yield curve inversion primarily reflects investors’ expectation the Fed will eventually have to cut interest rates, which in turn may reflect:
- a view that the Fed will go too far and push the economy into recession, or
- a view that the Fed has pushed the policy rate above its expected long-run average and that its success in bringing down inflation will allow it to later reverse course.
We think the latter may be the case.
While the Fed’s dovish pivot eased financial conditions somewhat in recent weeks, policy uncertainty has also receded in the U.S. (see chart 3). Shutdown risk got moved to early March, giving Congress more time to work on appropriation bills. There is also now a bipartisan bill in the works to extend expiring tax credits and cuts for households and businesses–which would provide a fiscal boost to growth–that appears to have a good chance to see the light of day by mid-year.
Our downside scenarios are improving, consistent with our observation that economic momentum remained resilient in the face of high interest rates in the second half of last year and financial conditions remained looser than the average since 1971. Given the leverage, credit, and risk components of the Chicago Fed’s National Financial Conditions Index up to the fourth quarter, the near-worst possible outcome (the bottom fifth percentile of the distribution) for annualized quarterly GDP growth in the next 12 months turned positive (see chart 4).
Fourth-quarter 2023 GDP slowed from the quarter before but was above trend at 3.3% (quarter-over-quarter annualized). We anticipate growth will soften more as the year progresses. The underlying potential of the economy limits the sustainability of further growth outperformance.
Downside risks could rise considering the ongoing conflict in the Middle East (which currently appears contained but could escalate). Real interest rates are still restrictive, and we remain wary that inflation could bounce back up, forcing the Fed to reverse its dovish tone, which would tighten financial conditions and dampen growth. Our dashboard of leading indicators doesn’t quite indicate that the coast is clear either, and coincident indicators are either in a late cycle or approaching one, which generally means there is limited scope for a short-run cyclical boost to growth.
Mixed Signals From Leading Indicators
Our comprehensive dashboard comprising 10 leading indicators presents us a more nuanced perspective. As of December, three indicators flashed negative signals, while five exhibited neutral or positive indications. Notably, credit spreads and consumer sentiment improved. With mortgage rates falling 100 basis points (bps) since November–and likely more as expected rate cuts come through during the year–the housing market may soon be bottoming out. The equity market has been performing well (although there is rising risk of a pull-back from a contrarian perspective), further adding to consumers’ wealth.
The good
Credit spreads.
Credit spreads narrowed since our last business cycle barometer report in September as financial conditions and inflation expectations eased. Speculative-grade credit spreads narrowed by 42 bps in December from November and by 79 bps from October (when the 10-year bond yield surged close to 5%). The investment-grade spread inched down by 16 bps in December from November and by 25 bps since October (see chart 5). Investors’ risk attitude has improved as both spreads are close to the middle of the last-10-year distribution.
Consumer sentiment.
Falling gas prices and cheaper durable goods together with persistent strength in the labor market have contributed to renewed consumer optimism, with the stock market hitting a new high (see chart 6). The University of Michigan’s consumer sentiment improved further in January to 78.8, its highest level in the past two and half years, from 69.7 in December.
This was the largest monthly gain since January 2006, following a still large gain of 8.4 points in December, mainly driven by the improving inflation outlook (both short-term and long-term inflation expectations plunged to near pre-pandemic levels). Moreover, consumer sentiment surged across income and age groups regardless of political affiliations–suggesting that the economy continued to display broad resilience at the start of the year.
Similarly, Conference Board’s Consumer Confidence Index jumped to 110.7 in December from 101.0 in November (see chart 7). The surge in confidence reflected positive views on economy in general, especially income, inflation, and business conditions. Consumer spending has been the main driver of sustained economic growth in the past three years, and improved consumer sentiment bodes well for consumer spending growth in the near term.
Consumer’s inflation-adjusted income and spending.
Real disposable income increased 2.5% quarter over quarter (versus 0.3% in the third quarter) and 4.2% year over year (versus -1.5% in 2022) in the fourth quarter. This led real personal consumption to rise 2.6% over the year in the fourth quarter. Inflation on a quarter-over-quarter basis slowed to 1.7% in the fourth quarter (see chart 8). Both goods and services spending supported last quarter’s private consumption spending. Despite relatively high interest rates, U.S. consumers continued to splurge.
Labor market.
The labor market has been a bright spot for the U.S. economy, supporting the consumer sector, which has been pivotal to overall economic activity. Wage growth, at 4.1% (year over year) in December, remained strong amid relatively tight labor market conditions.
Better than usual productivity growth has helped keep unit labor cost pressures on businesses at bay. The unemployment rate held steady at 3.7%, near its 50-year low. Initial jobless claims, a leading indicator of labor market activity, also remained near historical lows in the second week of January (see chart 9). Meanwhile, four-week average continuing claims declined for the second consecutive week, to 1.848 million. Continuing claims, unlike new claims, have drifted above 2018-2019 levels, suggesting that the pace of hiring is losing steam–leaving some jobseekers to look for work for longer.
The mixed
Freight.
The freight transportation index (which measures the quantity of freight carried by the for-hire transportation industry) rebounded in the fourth quarter following sustained weakness throughout the year, up 2% year over year in November after remaining flat in October. The improvement in freight movement aligned with the expansion of industrial activity in November (see chart 10).
Housing.
While home construction has been choppy throughout the year, the underlying trend shows single-family (which accounts for the bulk of housing construction) strengthening and multifamily weakening.
Housing starts edged down by 4.5% in December to 1.46 million units (seasonally adjusted annual rate [saar]) compared to the previous month but are up almost 9% compared to December 2022 (easy base effect). More importantly, building permits–a leading indicator for housing starts–picked up in December, rising 1.9% month over month to 1.495 million units (saar) and 6.1% year over year. The monthly rise was driven by single-family homes, which rose to the highest level since June 2022 (see chart 11). Multifamily (5+ units) permits also increased in December, up 1.4% from November, but followed a sharp 7.9% drop in the previous month.
The robust pipeline of apartment units currently under construction has cooled new development in the multifamily space. Meanwhile, optimism among single-family homebuilders rebounded in December as mortgage rates declined more than a percentage point and foot traffic increased.
To be sure, interest rates remain relatively high. It will take more than a percentage point move on mortgage rates to get would-be sellers to put their homes on the market. Many current homeowners bought or refinanced in 2020 and 2021, when mortgage rates were generally below 4%. of the level of homes up for resale is historically low. The annualized rate of existing home sales came in at 3.78 million units in December. Resales ended 2023 about 40% down from their late-2020 pace .
Financial stress.
According to the Federal Reserve’s Senior Loan Officer Opinion Survey, most banks reported tightened lending standards across all loan categories over the third quarter, signaling challenges to growth momentum (see chart 12). For the fourth quarter of 2023, banks reported expecting to marginally loosen standards on all loan categories. Still, loan growth remains anemic at best.
That said, a broader indicator of financial stress, which incorporates a wide variety of financial variables–the Chicago Fed’s Nonfinancial Corporate Index–remains positive and continues to signal that the U.S. financial system is operating at below-average levels of risk, credit, and leverage (see chart 13).
Furthermore, the Financial Conditions Impulse on Growth developed by the Federal Reserve–which assesses the extent to which financial conditions pose headwinds or tailwinds to economic activity–declined by 0.34 percentage points over the prior two months, reaching 0.53 percent (see chart 14). To be sure, this indicates financial conditions are weighing on economic activity still, equivalent to a 53 basis point drag on GDP growth over the upcoming year.
The bad
Manufacturing.
Surveys clearly depict the weakness in economic manufacturing business conditions in the country. The Institute of Supply Management (ISM) manufacturing index stayed below 50 in December for the 14th consecutive month. A reading of below 45 has coincided with a recession since the 1970s, but we have not reached that level yet. The ISM’s New Orders Index–a leading indicator of manufacturing activity–remained contractionary. The index came in at 47.1 in December, down 1.2 points from November.
S&P Global Market Intelligence’s New Orders Index was in contraction as of December (see chart 15). The preliminary numbers out for January showed the manufacturing output index at 48.7–a two-month high, but still a further drop in production since it is under 50. Positively, new orders ticked slightly above 50 in January, according to the flash estimate. Meanwhile, manufacturing nondefense new orders (excluding aircraft)–which go into GDP accounting–picked up in November on a year-over-year basis, although the pace has slowed (see chart 16).
Coincident Indicators Point To Economic Growth Slowing To Trend
Monthly data on the key coincident indicators suggests that the economy is in “late-cycle”. Measures of the estimated output gap suggest the economy is likely to slow below potential (about 2%), as we have been reporting, but growth should remain positive.
Labor market.
The labor market appears strong, albeit cooling. Job gains of 216,000 in December were well above market expectations (see chart 17), but the past three months average job gains have been 165,000, now slightly below the 2018-2019 average. This suggests that job gains are slowing to a more sustainable pace, consistent with the slower growth in the labor supply.
Furthermore, the employment to population ratio of prime-age workers (25-54)–a demographic unaffected by voluntary retirement–remained above the pre-pandemic average (see chart 18). That said, job openings fell to nearly a three-year low in November at 8.8 million, down from a high of 12 million in May 2022. So far, most of the correction in the labor market from high interest rates is coming through a lower vacancy rate (versus the typical rise in unemployment rate).
Manufacturing.
Overall, manufacturing sector data shows a broad-based slowdown. Production at factories ticked up in December by 0.1% month over month, largely driven by the increase in auto production that came after the end of a major auto strike, but contracted by 0.2% year over year for the fourth quarter (see chart 19). Industrial capacity utilization was unchanged in December at 78.6%, 1.1 percentage points below its long-run (1972-2022) average (see chart 20).
Freight.
With recent developments in the Red Sea, a critical trade route between Asia and Europe, the risk of a new price shock is rising. Disruptions in the supply chain have led freight rates across routes to spike, although they remain far below the 2021 peak. If the situation persists, we expect the manufacturers will pass on the prices to consumers, thereby pushing up inflation and potentially creating a challenge for the Fed.
Freightos global container rates rose by 113% as of Jan. 19 from mid-November (see chart 21), to $3,258 per 20-ft. container. Meanwhile, the container rate from Asia to Europe surged to $5,817 per container (a 236% increase since the unrest began in mid-November). Even freight rates to the U.S. East Coast jumped, by more than 81%.
Inventory management.
The inventory to sales ratio largely remained stable in the past few months, perhaps signaling stable inventory management for wholesalers, manufacturers, and retailers. The ratio for wholesalers dipped modestly in the fourth quarter, by 1.34% compared to the first half of 2023, but stayed above its long-term average and 2021 level, when it deteriorated due to supply disruptions. Retailers have shown better inventory management, with the ratio broadly stable throughout 2023 and up significantly from 2021 and early 2022. Improved inventory management also helped ease price pressures in the U.S. (see chart 22) from a multi-decade high.
Appendix
Other select indicators
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