If you’re looking toward economic data for clarity on the state of the US economy, rest assured you won’t find it there. Every day, observers change their stance, as one day’s news provides a different picture from the previous day’s news. And often, it seems like a never-ending stream of bad news—if it’s news about inflation (and the Fed’s reaction) one day, the next day’s headlines indicate a possible recession, followed by more bad news about inflation.
And yet, for all the noise, the US economy doesn’t look that bad. Employment growth remains strong, and many measures of economic activity are growing—even if more slowly than last year. Oil and food prices have been falling at the wholesale level, and consumers are beginning to see the results in stores. Gasoline prices fell below US$4 per gallon in August. Consumer spending remains positive as consumers continue to spend down the massive savings they accumulated during the pandemic. The recovery from the pandemic doesn’t appear to be over just yet.
Inflation, however, is likely to remain a concern. While lower energy prices push down headline inflation, core inflation has remained high. Shelter, a key element of core inflation, is likely to stay elevated for some time, as it catches up to the steep rise in house prices over the past two years. And prices of pandemic-related services such as airfare and restaurant meals may continue rising as those industries seek to replace workers who have retired or moved to other industries. The baseline scenario of the forecast presents an optimistic view of core inflation moderating by next year. But there is a significant possibility that it will take longer for inflation to settle back to an acceptable level, as illustrated in our “Back to ’70s inflation” scenario.
Talk of a recession occurring in the first half of 2022 was premature. Our experience in following the economy suggests that the state of the jobs market alone precludes the possibility that the economy was in recession before August. Two-quarters of negative GDP do not define a recession (see the sidebar, “Defining recessions (and the danger of revisions)” for more details). However, the possibility of a recession starting in the second half of 2022 remains too high for comfort. We’ve therefore included a scenario in which economic activity stalls in late 2022 and early 2023.
Fed hikes alone are unlikely to create a recession. The last recession that was “engineered” by the Fed was in 1981–82. At the time, the real Fed funds rate reached almost 10%. Today, the Fed is struggling to get the Fed funds rate into positive territory. The worst possibility is probably a 5% Fed funds rate coupled with a sudden decline in inflation to 2%. That would leave the real rate at 3%—definitely tight money for today’s economy, but nothing like the earlier experience.
A bigger problem is that rising interest rates tend to expose problems in financial markets. Higher interest rates are going to force lenders to take losses on existing mortgages and bonds. If the lenders haven’t made adequate provisions for those losses, the financial system might start to become stressed. That’s the real reason to be concerned as the Fed continues to raise interest rates at a hectic pace.
When the first estimate of GDP in the second quarter was negative, some commentators declared that the economy must be in a recession. After all, it was the second negative quarter in a row, and two negative quarters define a recession, right? Actually, this definition of recession has never been used in the United States. The idea was first proposed in 1974 by the then Commissioner of Labor Statistics, Julius Shiskin.1 But economists decided to approach the problem differently. The nonprofit National Bureau of Economic Research (NBER) maintains a committee of distinguished economists who determine business cycle dating.2 They track a broad range of economic indicators and normally make determinations about turning points some time after a business cycle peaks (when the economy starts contracting) or troughs (when the economy begins expanding again).
Many business cycle economists believe that GDP is too narrow to define a downturn. Also, GDP is subject to considerably large revisions. In some cases, contemporary GDP showed a decline of two quarters in a row, but subsequent revisions have changed the picture. The NBER Committee’s definition of recession is based on a wider set of indicators, so data revisions are less important.
And we have some hints that the two-quarter decline in GDP may be revised upward. A related measure of the economy, gross domestic income (GDI), grew 1.8% in Q1, and may have grown in Q2. Since every dollar of production results in a dollar of income, these two measures should, in theory, be the same. In practice, they are normally remarkably close, considering that the sources are completely different. But lately, statisticians have found more income than production. The large difference between them in Q1 may be closed once new data on income and production is incorporated into the National Income and Product Accounts in the annual update at the end of September.3
Of course, any definition of recession is arbitrary. The economy may avoid an “official” downturn even while some sectors may feel quite a bit of pain. It’s always good to remember the old saw: It’s a recession when your neighbour loses their job, and a depression when you lose your job.
Corporations and households borrowed at very low rates over the past few years. US companies issued over US$6 trillion worth of bonds at interest rates lower than 4%, in many cases lower than 3%. And households took out US$8.6 trillion worth of home mortgages over that period, at rates averaging from 4.5% (in 2017) to just 2.8% (in 2020). That’s a good deal for those borrowers. But somebody owns those securities. As interest rates rise, the value of those securities fall; if, for example, mortgage rates rise to 6%, a mortgage written at 3% is only worth about half of its par value.
Rising interest rates will eventually require the owners of these assets to mark them to the market prices. Exactly how this happens is a technical accounting and regulatory question. Some owners may be able to avoid this pain entirely, while others may be forced to take large losses. This may have a significant impact on capital availability, as lenders scramble to stay liquid, and turn down opportunities to invest in longer-term assets. An even bigger danger is that a systemically important financial institution might have bought a large amount of these long-term securities—enough that it is technically insolvent if/when it marks these assets to market.
The problem here is not that the collateral for debt is bad, or that debtors may have trouble repaying their loans. It’s not 2008 all over again; it’s a different problem because even good-quality debt has to be marked down when interest rates rise.
So far there is no sign of such a problem, and the fact that US banks passed their stress tests recently is a very good omen. But, as we saw in 2008, derivatives and the complicated organisation of key financial institutions can hide problems until they are forced into the open. The most likely way that the US economy could move from a slowdown/mild recession world to a severe downturn is if rising interest rates uncover weakness in financial markets.
Baseline (55%): Economic growth is slowing, but the economy continues to grow in the second half of 2022. There are some headwinds, such as tighter monetary policy and impact to global energy and food markets as a result of the Russian invasion of Ukraine. However, households continue to increase spending on pent-up demand for services such as entertainment and travel. Business investment continues to grow, 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. And the housing market causes a slump in residential construction. Inflation settles back to the 2% range by late 2023 as demand for goods slows and businesses solve their supply chain issues.
Back to the ’70s (15%): Households and businesses start to build anticipations of inflation into wage and pricing decisions. This reaction creates an inflationary spiral. The Fed is reluctant to engineer an actual recession and allows inflation to stabilise at a relatively high rate of 6%. However, tighter monetary policy slows the economy a bit, and the unemployment rate drifts upward.
The next recession (30%): Sticky inflation brings on more aggressive Fed tightening. Global energy and food problems add to the environment of uncertainty. The residential real estate market weakens, and businesses cut back on investment because of the uncertain environment. The faltering economy does allow supply chain issues to dissipate, eventually reducing inflation, but that’s not a lot of comfort to unemployed workers and unprofitable businesses.
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 estimated 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 has fallen to about 5% (compared to 7% before the pandemic). The baseline Deloitte forecast assumes that the savings rate will rise back to the 7% range, but that continued job and income growth will support continued growth in consumer spending. But spending could be even stronger if households decide to cash in more of those savings.
2. As 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 the second quarter of 2022, durables spending was down 6% from the peak in the second quarter of 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 2020.4
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.5 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.6
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:
All of these remain effective, except mortgage rates, which have begun to move up. The average rate for a 30-year fixed mortgage hit 5.78% in July 2022, up from just 2.9% in January 2021. That attests to the impact of recent Fed tightening, and expectations about further tightening as well. On top of that, the Fed has started to sell its stash of mortgage-backed securities. Between November and April, the Fed went from being a net buyer of mortgages to being a net seller of mortgages. The resulting squeeze has shown up in housing markets and in housing construction.
Deloitte expects construction to fall in the near term as high interest rates reduce demand and builders cut back. Housing may bounce back for a year or two after the current downturn runs its course. 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 worth of housing construction.
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 a little more than 1.5 million starts in 2027. 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.7
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. The overall recovery in nonresidential construction is likely to be limited by the continued low demand for office and retail space.
Mining structures also took a big hit because of the decline in oil prices earlier in the pandemic. As this is dominated by energy mining, it would be reasonable to expect a ramp-up in response to the historically high energy prices. But that hasn’t been the case, for two reasons. First, investors in this sector have been whipsawed in the past 10 years and are now less likely to react to what might be a temporary price increase. Second, the long-term prospect for fossil fuel investments looks weak, as a consensus develops about fighting climate change.
Investment in equipment has been growing at a fast rate. This is dominated by transportation equipment and (especially) information technology (IT) equipment. Remote work makes IT equipment (and software) a substitute for buildings, and so the counterpart to weak investment in commercial structures is a lot of investment in IT. The Deloitte forecast assumes continued growth in equipment investment, as both sources of demand are 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 is becoming a bit pricier as long-term interest rates rise. However, 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 5.7% and stays there through the end of the forecast horizon. Although that may appear high, historically it is relatively low. 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 likely be unable to generate sufficient returns to entice businesses to increase capacity.
The Russian invasion of Ukraine is making things more difficult for US exporters. Lower demand from Europe (market for 15% of US exports) and a higher dollar create some short-term challenges.
Beyond the Ukraine crisis, things look more positive. Real US exports remain substantially below the prepandemic level, and real imports are now higher than they were in late 2019. This, however, may eventually translate into opportunities for the United States as global financial and economic conditions normalise. More normal financial conditions can 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 recovers from the pandemic. Deloitte’s baseline forecast therefore assumes that exports will grow more quickly than imports over the five-year horizon. 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 talks 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 consider the possibility of deglobalisation. 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 globalisation 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 globalisation.
COVID-19 may have accelerated this shift. Although COVID-19 is a global phenomenon, leaders made major decisions about how to fight it—in both health and economic policy—on a country-by-country basis. Examples of this are the US withdrawal from cooperation in the World Health Organization in 2020 (although the United States has since rejoined) 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. All this was in stark contrast to the joint global approach that public health professionals might have recommended.
On top of this, the US-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.
On top of this, many businesses are 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. Globalisation has offered a comparatively painless way to improve many people’s standard of living; deglobalisation will likely involve painful costs and may limit real income growth during the recovery.
The big fiscal impulse from COVID-related spending has been largely reversed. The government contribution to GDP has been negative for the past three quarters, creating some fiscal drag. 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. (Recent spending bills will not have an immediate impact on spending, although they will help to support federal spending over the five-year forecast horizon.)
The new Inflation Reduction Act will likely have only a modest impact on inflation. Despite the name, the main impact of the bill will be felt years from now, not in the inflation numbers of the next few months. The bill’s main impact will likely be through the energy/climate change provisions, and those take years to have an impact. The tax provisions, while very important to certain taxpayers, are not likely to change overall tax collections or incentives for investment that much. And many people who buy health insurance through the Affordable Care Act exchanges will be helped by the extension of subsidies for medical insurance. But the overall impact on the deficit is likely to be modest. The Congressional Budget Office scoring showed a net decrease of US$90 billion over 10 years. In the context of a federal budget with almost US$7 trillion in outlays this year, US$9 billion in one year is just not a lot of money.
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.8 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 are becoming more difficult. 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 now become a normal state of US government budgeting—continuing resolutions and uncertainty lasting long past the beginning of the fiscal year.
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 could, however, be a bad idea to wait too long once those conditions lift.
The conversation about labour markets has switched—and fast. Not long ago, employment was millions below the prepandemic level, and the main question was how difficult it would be to get all those workers back on the job. Now employment is above the prepandemic level and business commentary is full of talk about labour shortages and stories about employers struggling to find workers. It’s hard to argue that the economy is experiencing a recession when the unemployment rate remains low, job growth is strong, and the ratio of job openings to unemployed people remains near record levels.
While employment has fully recovered from the pandemic, labour force participation has not. The July labour force participation rate was 1.3 percentage points below the rate in February 2020. That amounts to about 3.4 million people who are missing from the labour market. Who are those people? They are all older Americans. The labour force participation rate for ages 16–64 has been at the prepandemic level for most of this year. But the rate for people over 65 has fallen quite a bit. Many of these people have probably retired, in the sense of expecting to remain permanently out of the labour 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 labour 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 that job growth slows to sustainable levels (less than 100,000 jobs per month) in the next year. The unemployment rate remains low—and the job market remains relatively tight. Over the longer horizon, labour 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.
For over a decade before the pandemic, interest rates were unusually low. An inflation rate of around 2% suggests a neutral Fed funds rate of around 4%, but the funds rate remained close to 0 for 10 years after the global financial crisis. The pandemic seems to have jolted the financial system in a manner that requires higher interest rates—and the Fed is willing to oblige. Two 75-basis-point hikes and a third on the way suggests that Fed officials feel quite a bit of urgency in returning the Fed funds rate to something like a neutral position.
Although it seems extreme, the current policy is nowhere near as tight as the anti-inflation actions the Fed undertook during 1979–1982. At that time, the nominal rate went over 19%, and the real Fed funds rate hit almost 10% in one month. The current policy, on the other hand, seems to be aimed more at just getting the funds rate back to some neutral level, so that the Fed is not being so accommodating.
That’s cause for some optimism, but it doesn’t mean that interest rate hikes can’t cause pain. Long-term rates are rising, again to levels that would have been considered normal in the past. But if the corporate bond rate goes above 5%, as implied by our baseline forecast for a 5% 10-year Treasury, holders of past corporate bonds issued at the low rates of the past 10 years will have to eventually take a loss. Exactly how depends on the accounting and regulatory environment of the investor. Could this create systemic problems for the financial system? So far it looks like investing organisations have managed to prevent any significant impact from the repricing of low-return bonds. The success of US bank stress tests is an additional sign that the financial system is in good shape. But this remains an important potential problem for individual investors, and for the financial system.
Our baseline forecast assumes that the Fed will slow the size of interest rate hikes later this year as it becomes evident that inflation is slowing. We assume that the Fed funds rate will hit a maximum of 4 1/8 percent by March. Should inflation continue to be strong, as in our “Back to the ’70s” scenario, the Fed funds rate will be higher.
A Fed funds rate of 4% implies a significantly higher long-term rate. Our forecast has the 10-year Treasury note yield rising to almost 5% in the later years of our forecast. This is consistent with the historical relationship of these rates under moderate inflation: Should inflation continue to be high, the spread between the 10-year note and the Fed funds rate could continue to rise (as investors account for expected inflation in the later years of the note’s period). Investors should take care to watch for the possibility of high interest rates—although by the standards of the 1970s and 1980s, these rates are still quite low.
Of course, interest rates are always the least certain part of any forecast: Any significant news could, and will, alter interest rates significantly.
Some welcome signs of softening inflation have begun to appear. July’s unchanged headline CPI was dramatic, but more important is that core inflation was a relatively restrained 0.3% for the month. Falling energy prices will likely continue to push the headline CPI down for at least another month (although there is always the possibility of another geopolitical shock). But the erratic behavior of gasoline prices explains why “core” inflation is so important for determining monetary policy. Just as it would have been a mistake to overestimate inflation in the spring, when rising gasoline prices pushed the CPI up, it could be a mistake to underestimate inflation as gasoline prices fall.
At this point, the Fed will be examining the details of each price release to determine whether inflation is really softening enough to slow or stop the rate of monetary tightening. Core inflation is an important measure, in this case. But other details—such as the fact that the shelter component of CPI tends to lag housing prices9—will also play a role.
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 falling transportation prices and growing inventories. 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 8% in 2022. But by 2023, total inflation falls to 4.3%, and by 2024, 2.2%. We remain optimistic that today’s households and businesses will avoid the unpleasant experiences of the long inflation and painful disinflation that their predecessors felt during 1970–1985.
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