Based on RSM's economic forecasts, growth in the first quarter most likely expanded at a 2.35% pace versus the consensus forecast of 2%.
The Fed's interest rate hikes are beginning to curb growth, and tightening lending will likely cool the economy further.
But this growth will not last long: The debate over identifying the end of the business cycle is necessary, given the emerging consensus among economists that the economy will fall into recession this year.
RSM now predicts a 75% chance of a recession over the next 12 months, higher than its previous forecast of 65% for the second half of the year – a change driven by the increased likelihood of tighter lending standards following recent turmoil in the banking industry.
The increased likelihood of a recession follows a recent period of economic strength. The R word to use when it comes to the American economy should be resilience, not recession. The fact that we have not yet seen a recession despite nearly two years of rising inflation and interest rates is something that needs to be analyzed and understood.
But that resilience appears to be faltering. Federal Reserve rate hikes are beginning to curb growth, and tighter lending will likely further cool the economy in coming months. Despite that resilience, the risk of a recession cannot be discounted.
Business Cycle
The current economic cycle will likely go down as one of the shortest in American history.
In three years, the economy went from a health crisis-induced shutdown to a rapid recovery to a monetary policy-induced slowdown.
While it is the role of the National Bureau of Economic Research to identify the peaks and troughs of each business cycle after the fact, it is equally important for businesses and households to analyze the economic ups and downs and plan for the future.
Let's start with the NBER's definition of a recession. A recession is a significant decline in economic activity that is widespread throughout the economy and lasts for more than a few months. The NBER's analysis treats three measures of a recession – its depth, spread, and duration – somewhat interchangeably.
The most recent example is the sharp decline in economic activity during the pandemic, which lasted two months and swamped the NBER's traditional recession criteria.
In contrast, the NBER did not recognize two consecutive quarters of negative growth early last year as a recession, mainly because they did not occur at the same time as broad-based declines in employment and real final sales.
The NBER looks at several indicators to identify business cycle time series, including:
- Real personal income minus transfer income
- Nonfarm Payrolls
- Employment measured by household survey
- Real personal consumption expenditure
- Wholesale and retail sales taking into account price fluctuations
- Industrial Production
It is important to note the NBER's findings that economies are usually expanding. Recessions do occur, but they are usually short-lived.
Consider industrial production, a sector of the economy that is sensitive to interest rates and grows with business cycle expansion but often peaks long before the end of each cycle.
At the end of some cycles, industrial production has fallen sharply after the economy had fallen into recession, and more recently, in 2019, before the economy was hit by the 2020 health crisis, industrial production was already in contraction.
Although industrial production continues to grow, manufacturing sentiment has remained at levels consistent with a recession for the past four months.
And it's clear that the real estate sector, another area of the economy that is sensitive to interest rates, has been in recession for some time.
So what can we say about the possibility that this economic cycle will last only a few more months?
First, the Federal Reserve has determined that the economy's long-run interests are served by restoring price stability, which is a prerequisite for ensuring maximum sustainable employment, and that reducing inflation to acceptable levels is necessary to cool an overheated economy.
The impact of raising interest rates by 475 basis points over the past 12 months is finally starting to affect inflation, investment decisions, and increasingly the labor market. Upcoming economic data on gross domestic product (GDP) and personal consumption expenditures will likely show signs of further economic slowdown.
However, with underlying inflation still hovering between 4% and 5%, it will be some time before a safe signal on inflation is declared and policy rates are cut.
We expect the Federal Reserve to raise interest rates by 25 basis points at its next meeting on May 3 and do not expect any rate cuts this year.
As for the potential wage-price spiral, higher-wage manufacturing wages have fallen to an annual growth rate of less than 5% over the past two months.
Average hourly wages, which were growing 7% in March 2022 before the Fed began raising rates, have slowed to an annual growth rate of 5.1%, with most of that growth occurring in low-wage jobs.
In terms of employment opportunities, which indicate labor demand and ultimately labor costs, we are now seeing signs of labor market maturity, similar to what has happened at the end of each business cycle since the 1970s.
As expected, the demand for labor increases as the business cycle progresses. Increased economic activity leads to increased demand for labor, which in turn leads to reduced unemployment.
But as the business cycle weakens, demand for labor falls and unemployment rises. This can be seen several months before a recession officially begins.
For example, in September 2022, the Bureau of Labor Statistics reported a loss of 1.76 million full-time jobs. Six months later, the full-time job losses were nearly 2.12 million.
If this increase in unemployment were to continue, it would suggest an increase in the supply of available labor and a reduced need to pay higher wages.
Job losses and reduced incomes mean more willingness for households and businesses to spend and a slowdown in overall economic activity.
I don't think this will happen overnight. After the pandemic, companies will be reluctant to lay off workers who have been so hard to recruit.
The 2021-2022 infrastructure program will likely continue to create demand for labor, while government spending on defense will likely continue and a special supplemental spending bill to support efforts in Ukraine will likely be added. All of these developments will stimulate industrial production and mitigate job losses.
Yet recessions are typically the result of a financial or economic shock that pushes a mature business cycle into a recession.
Lending is almost certain to become tougher after recent turmoil at small and regional banks, which provide about 70% of commercial and industrial loans to small businesses.
This tightening of lending will further constrain real economic growth in the middle of the year, which is also when the next potential shock – a standoff over raising the country's debt ceiling – is most likely to occur.
Tightening lending and politically-driven financial turmoil could be the tipping point that turns the Fed-induced slowdown into a recession.