Odds stacked against US economy avoiding recession

WASHINGTON – Federal Reserve Chair Jerome Powell reckons the United States economy can skirt recession. But the odds are stacked against him – thanks to banking, politics, and even the weather.

In Mr Powell’s view, the gravity-defying strength of American labour markets – on display again in jobs data published last Friday (May 5), which showed a bumper increase last month – is smoothing the way for a soft landing, even after five percentage points of interest-rate hikes in little over a year.

“It’s possible that this time is really different,” the Fed chief told reporters last week after raising rates for a tenth straight time.

Still, a labour market that remains too-hot-to-handle means the Fed will have to hold rates higher for longer to quell inflation – the very reason recession risks are so high. And for Mr Powell’s forecast to come true, the US economy will have to overcome three major obstacles, all pointing to a downturn in the second half of this year.

A looming credit crunch. Driven by the combined impact of Fed tightening and bank failures, it will likely hit small businesses and commercial real estate especially hard.

A debt-ceiling deadlock in Washington. Coming to a head right now, the partisan standoff threatens a period of intense financial stress. If the US government does default, the blow to the economy and markets could rival the 2008 crash.

A climate wildcard from El Niño. The weather system is gathering force, threatening extreme conditions around the world that would disrupt commodity supplies, push prices higher, and keep the Fed focused on inflation.

And if this trifecta does tip the economy into a slump, there may not be much that Mr Powell and his colleagues can do about it. Rate cuts are the main recession-fighting tool – but it’s tricky for the Fed to deploy them when it’s still struggling to bring inflation back to target.

The fastest monetary tightening in four decades was always going to come at a price. The Fed has jacked up rates from near-zero to above 5 per cent since March last year. In recent history, the number of cases when that kind of policy didn’t lead to recession is precisely zero.

“I don’t believe there is a good example of a ‘soft landing’ in the five or so decades that the Federal Reserve has been mostly in charge of macroeconomic policy, and don’t see why the present situation should be different,” says James Galbraith, an economics professor at the University of Texas.

No accident

The dynamics that lead from higher rates to a shrinking economy are straightforward. As borrowing costs climb and asset prices fall, spending slows and businesses cut jobs. For central banks, that rise in unemployment – and the resulting drag on wages – is the mechanism that brings inflation back to target.

Recessions, in other words, are not an accidental side-effect of attempts to rein in inflation. They are the main show. That’s why, even when the Fed was just getting started with rate hikes last year, Bloomberg Economics forecast a downturn in the second half of 2023.

Then came the banking scare. The wave of failures that began with Silicon Valley Bank (SVB) was, in some sense, not a surprise. No one knew exactly what would break as the Fed hiked – but everyone suspected that something would.

If Fed officials could choose, though, they would probably not have picked collapsing regional banks as their preferred mechanism for delivering disinflation.

Bank failures amplify the effect of higher interest rates in curbing credit. Even last year, the Senior Loan Officer Survey – the Fed’s preferred barometer – showed lending standards getting tighter, and that trend will only accelerate after SVB. Typically, lending slowdowns follow with a lag after banks turn cautious, one reason to pinpoint the downturn in the second half.

What’s more, stresses in the banking system have a tendency to snowball. Early assurances that SVB was an extreme outlier now look wide of the mark, as contagion has spread. Taken together, bank failures in 2023 already rival those in 2008 in terms of asset size.