Why an American Recession Should Remain the Main Scenario

Could the Fed be wrong? In its recent projections, including the one for 2024, with a 50 bps decrease, the central bank no longer considers a recession as its primary scenario but rather a soft landing for the American economy.

Yet recent economic history would teach us to be cautious instead. The summer has indeed been sunny: inflation has decreased, jobs have remained plentiful, and consumers have continued spending. This weekend, a last-minute deal avoided a government shutdown.

But a significant strike in the automotive sector, the resumption of student loan repayments, and a potential shutdown after the temporary spending agreement expires could easily shave off a percentage point from GDP growth in the fourth quarter. Add to these shocks other powerful forces in the economy: the reduction of pandemic savings, surging interest rates and rising oil prices, and the combined impact could be enough to push the United States into a recession as early as this year.

The sell-off in September pushed the yield on 10-year Treasury bonds to a 16-year high of 4.6%. Higher and longer borrowing costs have already rocked the stock markets. They could also jeopardise the real estate sector’s recovery and discourage businesses from investing.

The United Auto Workers union called for a strike in all three major American automakers. It is the first time they have all been targeted simultaneously. Last Friday, they extended the strike to about 25,000 workers. The sector’s extended supply chains mean these stoppages could have an outsized impact. In 1998, a 54-day strike by 9,200 workers at GM resulted in the loss of 150,000 jobs.

There is also a complicated international context. The rest of the world could drag the United States down. The second-largest economy in the world, China, is mired in a real estate crisis. In the eurozone, loans are contracting faster than at the lowest point of the sovereign debt crisis, a sign that already stagnant growth is on the verge of slowing down further.

Consumption could also turn sour very quickly. The extra savings that Americans had accumulated during the pandemic have been depleted. The San Francisco Fed calculated that they would all be gone by the end of September. According to Bloomberg data, the bottom 80% of the population now has less cash than before Covid.

Furthermore, history and data suggest that analysts’ consensus has become too complacent, as before every American recession in the past four decades. “The most likely outcome is that the economy moves toward a soft landing.” This is what Janet Yellen, then president of the San Francisco Fed, declared in October 2007, just two months before the start of the Great Recession. Yellen was not alone in being optimistic.

Millions of Americans will start receiving student loan bills again this month after the expiration of the three-and-a-half-year pandemic freeze. The resumption of payments could further reduce fourth-quarter annualized growth by 0.2 to 0.3%.

The advent of BRICS in January 2024 will profoundly alter the geopolitical dynamics around energy and raw materials. The inclusion of Saudi Arabia, the world’s largest oil exporter, alongside Russia, Iran, the United Arab Emirates, and Brazil, brings together many of the world’s major energy producers and largest developing consumers, giving the bloc disproportionate economic weight. The West will likely have to pay more for its energy.

We have not seen the full impact of the rate hikes on the economy, especially on the employment variable. Typically, it takes 18 to 24 months to measure the effect of a rate hike on unemployment.

This means that the full force of the Fed’s rate hikes, 525 basis points since early 2022, will only be felt at the end of this year or in early 2024. It is currently premature to say that the economy has weathered this storm. And the Fed may still need to finish raising its rates. In their latest projections, central bankers foresee another rate hike before the end of this year.

Credit indicators also do not favour a soft landing for the American economy. One indicator with a track record of anticipating slowdowns is the Fed’s Senior Loan Officer Opinion Survey on Bank Lending Practices, known as SLOOS. The latest data shows that about half of large and midsize banks impose stricter commercial and industrial loan criteria. Aside from the pandemic period, this is the highest share since the 2008 financial crisis. The impact is expected to be felt in the fourth quarter of this year, and when businesses can’t borrow as easily, it usually leads to a slowdown in investments and hiring.

For economists, these past few years have been a lesson in humility. Faced with seismic shocks caused by the pandemic and the war in Ukraine, forecasting models that worked well in times of prosperity completely missed their mark. All of this gives good reason to be cautious. A soft landing is still possible. But is it the most likely scenario?“

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