Recessions happen

The Fed tightening that started in March has been accompanied by increasing talk of a recession. It’s certainly true that a recession is more likely now than it appeared six months ago. The US economy faces a number of headwinds, and, while none of them are enough to stall the recovery, the confluence of so many issues is worrisome. We’ve discussed these problems in more detail in our recent Economics Spotlight, Headwinds outside of the United States pose a challenge to growth and policymakers.

We’ve added a recession scenario to our forecast. But we still think a recession is less likely than some analysts would have you believe. When the economy is currently adding almost half a million jobs per month, a turnround would take time (unless, of course, a second pandemic hits the globe). For that reason, we expect any coming recession to occur at the earliest in late 2022 or 2023.

The main argument for a recession is that one usually occurs after the Fed starts hiking interest rates. That is true, but only part of the story. Just because recession occurs after the tightening cycle has started does not mean that the tightening caused the recession. Recessions occur because of shocks in the economy (see: What to expect when you are expecting … a recession).

Recent recessions have not, in fact, been associated directly with Fed tightening. The 2001 recession, for example, followed the bursting of the stock market bubble, while the 2007–09 recession followed the housing crash (and the subsequent financial crisis). The most recent recession was the result of a global pandemic and had no connection to monetary policy.

In all of these cases, Fed tightening started well before the downturn. In some cases, such as before the Global Financial Crisis in 2007–08, the Fed started lowering rates well before the recession. In fact, since the mid-1950s, US business cycle peaks have occurred an average of 38 months—more than three years—after Fed tightening started. The shortest period between the onset of a Fed tightening period and a recession was 20 months (the 1973 and 1960 recessions).

All of this does not mean that a recession is unlikely, or that chances of a downturn aren’t rising. Indeed, the Deloitte forecast now includes a recession scenario albeit with a relatively low probability of 15%. Rising interest rates do pose the danger of uncovering financial imbalances or systematic risks in the financial system. Add an oil price shock on top of rising interest rates, a possible recession in Europe if Russian natural gas supplies are stopped, and the continued impact of the pandemic, and a US downturn could certainly happen. But it’s not necessary to overstate the risk.

It is necessary to remember that COVID-19 isn’t over. The virus is circulating and mutating, and a new variant could emerge—a variant that might force further economic adjustment. The Deloitte forecast includes a scenario (with 5% probability) that a new strain of the virus requires another bout of social distancing and shutting down of public spaces, which would once again slow economic growth in the near term.

In the longer run, the fundamental factors behind the US economy have not changed. Slowing population growth and the question of whether new technology can be translated into higher productivity growth will determine the state of the economy ten, twenty, and fifty years in the future.

Scenarios

Baseline (55%): Growth continues in 2022 as the impact of COVID-19 wanes, although some slowing occurs as the economy reaches full employment, monetary policy becomes tighter, COVID-19–era fiscal impulse reverses, and the Russian invasion of Ukraine affects energy and food markets. Households continue to increase spending on pent-up demand for services such as entertainment and travel. However, spending on durable goods stalls as consumers switch back to prepandemic patterns. Business investment continues to grow rapidly, particularly in information-processing equipment and software. Investment in nonresidential structures remains weak, however, as the oversupply of office buildings and retail space weighs on the market. The infrastructure spending bill raises the level of government spending modestly for most of the forecast period. All of this helps elevate demand above the pre–COVID-19 trend for several years. Inflation remains above the Fed’s target in 2022, but gradually settles back to the 2% range by mid-2023 as demand for goods falters and businesses solve their supply chain issues. The pandemic jump-starts the widespread adoption of new technology, leading to faster productivity growth. The Fed raises rates at a relatively fast pace in 2022 out of concern for inflation, then slows rate hikes as inflation falls back to the normal range.

Relapse (5%): The discovery of new omicron variants underlines the risks that COVID-19 continues to pose to the US economy. New variants are constantly being found.¹ In this scenario, the current vaccines are not as effective against one or more new variants and hospitalizations and deaths again start to rise. People return to social distancing and cut back on purchasing services that are perceived as “risky.” This slows growth substantially. A muted government response results in financially stretched businesses failing, and weakened balance sheets for certain sectors create the conditions for a more traditional, slower recovery from the recession. After continued outbreaks, consumers permanently reduce spending on travel, entertainment, food, and accommodations, requiring a painful readjustment of the economy.

Back to the ‘70s (25%): Households and businesses see price hikes from pandemic-related shortages and react by raising prices and wages. The reaction, and consequent rise in inflationary expectations, creates an inflationary spiral. Consumer prices are rising at a steady rate of over 5% by the end of 2022, causing the Fed to raise interest rates to limit demand. In 2023, inflation continues, but a “growth recession” causes the unemployment rate to rise. The Fed is reluctant to engineer an actual recession, and inflation settles in at a 4% rate over the five-year forecast horizon.

The next recession (15%): Aggressive Fed tightening slows housing markets and business investment very quickly. Global energy and food problems slow growth abroad as well as in the United States, and global investors’ preference for dollar assets keeps the dollar high and cuts further into US exports. Employment growth falters and then reverses as demand softens. Once the unemployment rate begins to rise, businesses and consumers cut back abruptly on domestic spending, leaving businesses with an unwelcome rise in inventories that induces a quick fall in production. The faltering economy does allow supply chain issues to dissipate, reducing inflation, but that’s not a lot of comfort to unemployed workers and unprofitable businesses.

Sectors

Consumer spending

The near-term outlook for consumer spending turns on two big questions: 

1. Will consumers spend down all those pandemic-era savings?

In 2020, during the height of the pandemic, we estimate that households saved about US$1.6 trillion more than we forecasted before the pandemic. Some of that went into investments, but many households have a lot more cash on hand now than they normally would want. How much of that will they spend as the pandemic impact wanes? One possibility is that many consumers will remain cautious and hold on to those savings even as they are able to go out and spend. Another possibility: Spending booms for a while longer as the impact of COVID-19 continues to wane. We’ve already started to see that happen, as the savings rate nears 6% (compared to 7% to 8% before the pandemic). The baseline Deloitte forecast assumes that the savings rate will remain low. That’s enough to support continued growth in consumer spending. But spending could be even stronger if households decide to cash in more of those savings.

2. When consumer services recover, what happens to durable goods?

The pandemic sparked a remarkable change in consumer spending patterns. Spending on durable consumer goods jumped US$103 billion in 2020, while spending on services fell US$556 billion over the same period. Households substituted bicycles, gym equipment, and electronics for restaurants, entertainment, and travel. Once households can again purchase services, will they begin buying fewer goods? That may be happening, as by March 2022, durables spending was down 11% from the peak in March 2021.

Deloitte’s forecast assumes that durable goods spending continues to fall over the next few years as consumer spending “renormalizes” and consumers resume spending on services. For a more detailed consumer spending forecast, see: Consumer spending forecasts: Services find their way back after a forgettable 2020.

In the longer term, we expect the pandemic to exacerbate some existing problems. It has thrown the problem of inequality into sharp relief, straining the budgets and living situations of millions of lower-income households. These are the very people who are less likely to have health insurance—especially after layoffs—and more likely to have health conditions that complicate recovery from infection. And retirement remains a significant issue: Even before the crisis, fewer than four in 10 nonretired adults described their retirement as on track, with a quarter of nonretired adults saying they had no retirement savings.² The stock market boom will have little impact on most people’s balance sheets, leaving many people still unable to afford retirement as they age.³

Housing

The housing sector has outperformed the broader economy in the wake of the pandemic, as buyers and sellers found ways to navigate the pandemic’s restrictions. A host of factors combined to boost housing demand over the past two years:

• The continued strong economic position of high-wage remote workers
• Growing expectations that remote work will persist after the pandemic
• Historically low mortgage rates
• Millennials moving into prime home-buying age

All of these remain effective except mortgage rates, which have begun to move up. The average rate for a 30-year fixed mortgage hit 5.49% in May 2022, up from just 3.14% in May 2021. That attests to the talk of Fed tightening, and reflects expectations about the Fed’s actions (since the two Fed hikes through late May amount to raising the Fed funds rate to just 0.83%). On top of that, the Fed has started to sell its stash of mortgage-backed securities. Between November and April, then, the Fed went from being a net buyer of mortgages to being a net seller of mortgages. The resulting squeeze is starting to show up in housing markets and in housing construction.

Deloitte expects demand to cool due to reduced affordability in the medium term. Nominal home price increases and rising mortgage rates will both slow the interest of potential homebuyers. Despite the slowdown, demand is likely to exceed supply in the medium term as builders continue to grapple with supply chain issues and land-use restrictions. The Deloitte baseline forecast expects house prices to rise faster than inflation through the forecast horizon.

Beyond the short term, however, the fundamentals for housing demand appear relatively soft. Housing vacancies are low, but it would only require 1.6 million additional units to return vacancy rates to 1990s’ levels. That’s about a year’s housing construction, and would probably allow a housing boom to last for several years, but not much longer than that.

Demographics, meanwhile, suggest that housing is not likely to become a key driver of economic growth in the foreseeable future. Population growth has slowed to about 0.5% per year (compared to over 1% during the 2000s’ housing boom). The baseline forecast assumes that housing starts will fall over the five-year horizon to 1.5 million starts in 2026. Faster medium-term growth in housing would require faster population growth, most likely from immigration. Otherwise, the current heightened demand for housing is likely to be a short-term phenomenon.⁴

Business investment

Businesses have ramped up investment since the initial impact of the pandemic, but they have been selective about what they are investing in.

Investment in nonresidential structures continues to be down (more than 20%) from the prepandemic level. The business case for office buildings and retail space has collapsed with online shopping and the shift toward working at home. Mining structures also took a big hit because of the decline in oil prices earlier in the pandemic. There are signs that construction of mining structures has begun to reverse, which may help boost the sector temporarily. However, the overall recovery of the nonresidential construction is likely to be limited by the continued low demand for office and retail space. 

Investment in equipment has been growing at a fast rate. The Deloitte forecast assumes continued growth, as the need for transportation equipment (to move goods) and information-processing equipment (to support telework) is likely to remain strong.

Investment in intellectual property (which consists primarily of software and R&D) accelerated during the pandemic (after dropping in the first quarter of 2020). That’s mostly because of investment in software, and it likely reflects the investments needed for telework. We expect this category to remain strong over the next few years as businesses continue to require software to accompany their investments in information-processing equipment.

Financing investment should remain relatively easy, despite concerns about higher interest rates. Nonfinancial businesses are sitting on a pile of cash, and interest rates are still relatively moderate. In our baseline forecast, the corporate bond rate rises to 4.7% and stays there through the end of the forecast horizon. Even adding in the potential for a corporate tax hike, the cost of capital is likely to remain low enough to boost businesses’ ability to pay for all those new computers and servers, not to mention the software to run them. But even with easy financing terms, office and retail space will be unable to generate sufficient returns to entice businesses to increase capacity.

Foreign trade

The Russian invasion of Ukraine is likely to make things more difficult for US exporters. Lower demand from Europe (market for 15% of US exports) and a higher dollar will create some short-term challenges.

Beyond the Ukraine crisis, things look more positive, even though real US exports remain substantially below the prepandemic level, and real imports are now higher than they were in late 2019. This may eventually translate into opportunities for the United States as global financial and economic conditions normalize. More normal financial conditions will create more opportunities for investment outside the United States and less desire to hold dollars to avoid risk, lowering the dollar and making the United States more competitive globally. And demand for US goods is likely to rise in the medium term as the global economy returns to recovery from the pandemic. Deloitte’s baseline forecast therefore assumes that exports will grow more quickly than imports. As a result, there is a modest improvement in the current account deficit over the forecast horizon. Of course, much depends on how trade policy develops, and whether businesses actually follow through on talk about “reshoring” in response to supply chain disruptions. 

But there is another trend that is critical to consider. Over the past few years, many analysts have begun to face the possibility of deglobalization. Global exports grew from 13% of global GDP in 1970 to 34% in 2012. But then the share of exports in global GDP started to fall as globalization began to stall, and opponents of freer trade started to gain more political influence. All this points to an unraveling of the policies that fostered the earlier globalization.

COVID-19 may have accelerated this tendency. Although COVID-19 is a global phenomenon, leaders have made major decisions about how to fight it—in both health and economic policy—on a country-by-country basis. The most striking examples of this are the US withdrawal from cooperation in the World Health Organization in 2020 (although the United States has since rejointed) and the unilateral decisions of both China and Russia to deploy their own vaccines before the completion of phase 3 trials. And countries with vaccine-manufacturing facilities rushed to vaccinate their own citizens rather than cooperating on a global vaccination plan.

On top of this, the United States-China trade conflict continues. The White House has shown some interest in returning to a multilateral approach to trade—for example, by supporting Ngozi Okonjo-Iweala for the World Trade Organization director general. However, US Trade Representative Katherine Tai has made a point of stating that trade policy should be aimed at helping US workers. And many of the Trump-era tariffs remain in place, with little prospect that the tariffs on China, in particular, will be withdrawn.

Many businesses have been considering rebuilding their supply chains to create more resilience in the face of unexpected events such as the pandemic and changes in US trade policy. The imperative for such changes has become stronger with the increasing supply chain issues and port delays facing importers of key components and consumer goods. It’s impossible, of course, to simply and quickly refashion supply chains to reduce foreign dependence. American companies will continue to source from China in the coming years. But companies will likely accelerate attempts to reduce their dependence on China (a process they had begun before the pandemic). Building more robust supply chains may mean moving production back to the United States, or perhaps to Mexico or some other, closer source. Or it may mean a portfolio of suppliers rather than a single source—even if the single source is the cheapest.

Re-engineering supply chains will inevitably mean a rise in overall costs. Just as the “China price” held inflation in check for years, an attempt to avoid dependency on China might create inflationary pressures in the later years of our forecast horizon. And if markets won’t accept inflation, companies will have to accept lower profits to diversify supply chains. Globalization has offered a comparatively painless way to improve most people’s standard of living; deglobalization will involve painful costs and may limit real income growth during the recovery.

Government policy

President Biden’s Build Back Better plan appears unlikely to pass at this point. That leaves federal budget policy on a much more modest path than what might have been expected last year.

It’s true that the infrastructure spending bill— already in place—will boost government spending over the next 10 years. This spending will increase the capacity of the economy and likely help to drive some additional productivity growth. Much of this additional spending comes toward the end of our forecast horizon, however. The total spending impulse will be moderated by higher inflation. And the amount of spending is relatively modest compared to the economy as a whole. According to the Congressional Budget Office, in 2026, the peak year of spending, the bill will add about US$61 billion to the federal deficit.⁵ That amounts to about 0.2% of projected GDP. The infrastructure bill is likely to have a positive and significant impact on public capital in the United States, but it’s not a large fiscal stimulus by any means.

Meanwhile, Congress and budget politics have returned to prepandemic norms. In this case, it’s not a good thing, as the prepandemic norm was difficulty passing the basic legislation to fund the government. Congress did finally pass an appropriations bill, in late May, for FY2022. The next fiscal year starts in October, so the fall will see what has become a normal state of US government budgeting—continuing resolutions and uncertainty lasting long past the beginning of the fiscal year.

Fiscal policy has turned contractionary. The disappearance of pandemic-era income support is creating a significant fiscal drag. In the second half of 2021, household income from employee compensation rose over half a billion dollars, but a decline in personal transfer receipts from the federal government offset about a quarter of that additional income. This is weakening demand and is one of the reasons the baseline forecast expects inflation to moderate by 2023. Essentially, the federal government is adopting a restrictive policy that is likely to dampen demand, while at the same time the Fed raises interest rates. It takes time for both fiscal and monetary policy to affect demand. The danger is that both types of policy have turned too restrictive, and, when the full impact of both is felt, the economy is expected to slow too much.

Our baseline forecast assumes deficits will fall by 2022 to below US$1.4 trillion per year, and then rise slowly. That’s a hefty amount, one that inevitably raises the question of whether the US government can continue to borrow at such a pace. The answer is that it can—until investors lose confidence. At this point, most investors show no sign of concern about US debt. In fact, very low interest rates on US government debt indicate the world wants more, not less, American debt. We anticipate no problem over the forecast horizon.

But the government will face a crisis if it does not eventually find ways to reduce the deficit and consequent borrowing. The crisis may be many years away, and current conditions argue for waiting. It would, however, be a bad idea to wait too long once those conditions lift.

Labor markets

The conversation about labor markets has switched—and fast. Not long ago, employment was about 10 million below the prepandemic level and the main question was how difficult it would be to get all those workers back on the job. Now business commentary is full of talk about labor shortages and stories about employers struggling to find workers. That seems a bit odd since employment is still lower than the prepandemic level—although it’s currently growing fast.

Many pundits have seized on several reasons why businesses are experiencing so much trouble hiring workers.

Generous government benefits kept people out of the labor force. This explanation makes some sense, but there are reasons to doubt that it is the whole story or, perhaps, even a major part of the story. Some economic research suggests that the original US$600 weekly supplement to unemployment insurance did not affect businesses’ ability to rehire workers during the earlier part of the recovery. However, anecdotal evidence is strong enough to suggest that the unemployment insurance supplement may have contributed to the problem. The last of these benefits ended in September 2021, however. The only possible impact in 2022 would be because some people saved money and are therefore able to remain selective about the jobs they are willing to take.

Child care has prevented a significant number of people from re-entering the labor force. The Bureau of Labor Statistics estimates that the labor force participation among parents of children under 18 years fell about 1 percentage point in 2020. The good news is that this problem is on its way to being solved, with schools having reopened. Day cares, however, still face enrollment limits in some states, and are among the businesses that have the most trouble finding staff, which limits the ability of parents of small children to re-enter the labor force.

Health remains a concern for people who are at risk of COVID-19, particularly those who cannot be vaccinated due to a high risk of complications.

About half of the decline in the labor force is among people 55 years and older. Many of these people have probably retired, in the sense of expecting to remain permanently out of the labor force, but some can likely be enticed back with the right compensation packages and flexible working hours and conditions.

As is the case in many areas, the pandemic accelerated trends that were evident before it started. Slow labor force growth and continued high demand had already created conditions that required companies to offer higher wages to lower-skilled workers and to be more imaginative about hiring. In the post–COVID-19 world, companies that make extra effort to find the workers they need and provide conditions to attract those workers will have an important competitive advantage.

Deloitte’s baseline forecast assumes a strong job growth over the next year as employers do, in fact, find and rehire those missing workers. However, labor force participation rises over the next year as potential workers become more comfortable returning—or are forced to because of lack of income. As a result, we see the unemployment rate remaining at around 3.5%.

But most importantly, over the longer horizon, labor force growth slows to just 0.2% per year, presenting continuing challenges for employers. It’s a demographic fact that employers will have to learn to live with

Financial markets

The Fed’s actions had been one of the bright spots of the US response to the pandemic. When the virus first began spreading, there was a significant possibility that a financial market meltdown would exacerbate the country’s economic problems. The Fed’s prompt and strong actions kept financial markets liquid and operating, preventing that additional level of pain.

With GDP now above the prepandemic level, strong employment growth, and some signs of more prolonged inflation, the Fed has started to unwind its pandemic response. “Tapering” purchases of long-term assets (“quantitative easing” or QE) began at the early November 2021 FOMC meeting. At the May 2022 meeting, the Fed announced that it would reduce its holdings of long-term securities by letting them “run off,” which means not reinvesting the proceeds it receives from maturing securities. This is a remarkably fast turnaround in policy.

Since the beginning of the financial crisis, the Fed has accumulated over US$8 trillion of long-term securities. Current plans are to limit the amount of “run-off” to about US$100 billion per month (half that for the first few months). Reducing its holdings to an acceptable level may take some time. And, of course, expect the Fed to act flexibly and reduce its net sales of assets if the need arises.

The pressure on the Fed to begin raising the funds rate has intensified. In November 2021, Fed officials were suggesting that the first rate hike would occur in late 2022. By February, Fed watchers considered a hike at the March meeting very likely, and there was some discussion of a 50-basis-point hike to send a signal to market. By May, the Fed had hiked in two meetings, including one 50-basis-point hike (at the May meeting) with more expected to come.

The baseline forecast assumes at least one additional 50-basis-point hike this year, and 25-basis-point hikes at the other FOMC meetings. This would take the funds rate up to 21.5% by the end of the year. The forecast includes three additional hikes in 2023. This is consistent with our assumption that inflation will decline by late 2022, which would take a lot of pressure off the Fed. We expect the Fed to stop hikes when the funds rate is a bit above 2.88%, leaving real short-term interest rates in (just barely) positive territory.

We expect long-term rates to rise as well, reflecting the global economic recovery and the rise in short-term rates. By 2026, the 10-year Treasury stands at 4.38%. That may seem high today, but is, in fact, low in the historical context. It would imply a spread between long- and short-term rates that is only about half the level the economy normally experiences in full employment. The possibility that, in a booming economy, long-term interest rates might rise by even more should not be dismissed.

Of course, interest rates are always the least certain part of any forecast: Any significant news could, and will, alter interest rates significantly.

Prices

The news media has been flooded with reports about inflation for some time. Before the Russian invasion of Ukraine, that commentary tended to underplay how much of the rise in prices was due to specific supply chain problems that were likely to be alleviated over time. Businesses were already finding ways around some of these shortages, and the rotation of consumer spending from goods to services is also removing some pressure on supply chains. The significant bump in prices in Q2 from higher food and oil prices complicates, but does not negate, that picture. However, the Ukraine crisis does add to short-term price pressures. The real question, however, remains the same as before the Ukraine crisis: whether inflation becomes baked into the economy. Our “Back to the ‘70s” scenario explores that possibility.

CPI inflation first accelerated in March 2021, although the March increase was mainly due to higher energy costs. The next three months—April to June—saw much higher core inflation. Most of the acceleration, however, was due to a few specific pandemic-related categories. And then, inflation decelerated back to acceptable levels for three months,⁶ although the news media ignored this. However, many economists understood that the signals were consistent with the “transitory” inflation story the Fed was describing.

In October, inflation accelerated again and has remained elevated since then. The overall level of inflation (6%–7% on a year-over-year basis) is still relatively mild compared to inflation in the early 1980s (about twice that rate) or in many other countries that have experienced inflationary problems. But more important, inflation looks … odd. It’s still heavily driven by a few unusual categories such as used cars. And goods inflation has accelerated much more than services inflation. That’s very unusual, since goods inflation has been lower than services inflation for the entire post–World War II period. Economists have long understood that this is to be expected because of long-term technological changes. Simply put, services production is much harder to automate than goods production. The high level of goods inflation is, therefore, unlikely to continue unless services inflation also accelerates.

But there are some warning signs. Among them are the spread of inflation to some areas that are not recovering from a postpandemic price decline (apparel, for example), and the rise in shelter prices. Shelter, and its subcomponent that measures the implicit rise in housing prices for homeowners (“owners’ equivalent rent of residences”), appears to respond with a lag to higher housing prices. And housing prices by the widely used Federal Housing Finance Agency measure are up 27% from the prepandemic level, while owners’ equivalent rent is up just 5.2%. We may see elevated readings for the CPI over the next year as the CPI for shelter catches up with housing prices.

The Deloitte forecast continues to assume that the current inflation is “transitory” in the sense that it will dissipate over time. Companies are already finding ways around many of their supply chain problems, as evidenced by high factory utilization and growing industrial production. And our forecast of declining demand for consumer durables suggests that the need for expanded production will gradually decline, reducing the bottlenecks that are currently frustrating producers and leading to higher prices. Our baseline forecast shows CPI inflation spiking to over 7% in 2022 (although core inflation is “only” up 5.7%). But by 2023, total inflation falls to 2.5%—although core inflation is higher, because very high food and energy prices are likely to come back down to earth as production increases and energy demand moderates as the global economy slows.

Appendix

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