After rapid recovery, watch for sudden slowdown
The 2020 recession was the deepest on record and the shortest. The recovery has become the fastest since the 1980s while generating the largest rise in inflation since the 1970s. Attribute this atypical cycle to the demand and supply disruptions caused by the pandemic and the subsequent reopening of economy, and the extraordinary degree of fiscal and monetary stimulus in response.
It’s a safe bet that the next phase won’t be typical either: the economy could start to slow down abruptly, for three reasons.
First, fiscal policy has boosted demand in 2020 and 2021, thanks to stimulus checks, improved unemployment insurance, money for state and local governments, an expanded child tax credit, and repayable business loans. Almost all of them have expired, and apart from a few measures such as state-level tax cuts, nothing new is replacing them. Fiscal support contributed 7.6 percentage points to inflation-adjusted gross domestic product in the first quarter of 2021, according to the Hutchins Center on Fiscal and Monetary Policy, a think tank affiliated with the Brookings Institution. He subtracted 2.1 points in the first quarter of this year.
Personal incomes, supported by government transfers until the end of last year, are growing much more slowly now. This would normally not be a problem since incomes are growing rapidly and job creation is rapid.
This brings us to the second reason for a slowdown: purchasing power has been undermined by inflation. Higher gasoline prices, in particular, act exactly like an increase in taxes. As a result, wage income, which has grown at a blistering 10% annual rate over the past three months, fell 1.2% when adjusted for inflation.
Some of this pressure will ease in the coming months if prices for gasoline, used cars and some other items fall, as expected. Meanwhile, however, consumers will face a third headwind: rising interest rates. The Federal Reserve slashed rates to near zero when the pandemic hit in early 2020 and began buying billions of dollars in bonds. The central bank maintained both policies even as the economy bounced back and inflation rose.
But since December 2021, the Fed has pivoted hard, revising up rates that will rise and charting plans to dump its bond holdings. The yield on two-year Treasury bills, an indicator of the degree to which markets expect the Fed to raise interest rates, is still relatively low at 2.4%. But its two percentage point rise over the past six months is the biggest since 1994. The 30-year mortgage rate hit 5.13%, the Mortgage Bankers Association reported on Wednesday, up 2.1 points at the six months, also the fastest since 1994. This translates into an even steeper rise in monthly mortgage payments: the National Association of Realtors’ Housing Affordability Index was at its lowest level in 13 years in February, before the last mortgage rate hike.
Predicting the effect of these headwinds is complicated by the unusual nature of this cycle. Much of the surge in demand and inflation over the past two years has focused on goods. Some of that could reflect a one-time spending spree as consumers outfitted home offices, purchased exercise equipment or replaced appliances. This could leave companies vulnerable to the “Peloton Effect,” a sudden drop in orders as consumers conclude they have enough, as Peloton Interactive, which sells web-connected exercise bikes, has lived last year.
On the other hand, consumers are teeming with cash from past stimulus and rising stock prices, which could support spending for some time. And some economists argue that demand for cars, houses and other goods was artificially depressed by the 2007-09 recession; what seems unusually high today may actually be back to normal. Finally, demand has been so much higher than supply that a slight pullback may not affect production plans much, especially with relatively low inventories.
Nevertheless, some weakening in demand seems inevitable. Private data tracked by the Federal Reserve Bank of Chicago points to a 2.9% drop in non-vehicle retail sales in March from February, or 4.2% when adjusted for inflation. First quarter economic growth was likely close to zero.
The transformation of such a slowdown into a recession depends essentially on the labor market and inflation. Payroll growth, which has averaged 600,000 per month over the past six months, is expected to fall significantly before turning negative, a precondition for a recession.
Moreover, “the unusual strength of labor demand is primarily reflected in an unusually high level of job vacancies, not an excessive level of employment,” Goldman economists noted this week. Sachs. An employer who reacts to the drop in demand by not filling a vacancy avoids the damage caused by layoffs via the drop in income and purchasing power.
Indeed, if higher interest rates and lower real incomes serve primarily to reduce excess demand, they may alleviate some of the pressure on supply chains that has fueled inflation. In this case, the Fed would not have to raise interest rates as much, which would also reduce the risk of a recession. This is not usually what happens when inflation is so high to begin with, and inflation has spread far beyond the sectors most directly affected by pandemic shortages. But nothing in this cycle is typical.
This story was published from a news agency feed with no text edits