The probability of a recession increases; it is too early to predict it, but not its effects
Inflation has now been above the 2.0-2.5% level that the Federal Reserve targets for the normal rate of inflation for 18 months.
To slow this rate of inflation, the Fed raised its benchmark interest rate five times, from 3.25 to 6.25%. This has the effect of increasing the cost of borrowing, thereby reducing consumer demand. It also increases the risk of recession.
It’s too early to predict a recession, and economists, including this columnist, have a poor track record of predicting recessions. However, it is not too early to think about what we might expect in a recession and the unexpected risks that might accompany a downturn.
The goal of the Fed’s higher interest rates is to get consumers and businesses to buy fewer goods and services. Naturally, higher inflation prices cause consumers and businesses to change the range of products they buy, but that doesn’t necessarily reduce demand. Higher interest rates reduce demand, especially for big-ticket items such as automobiles, recreational vehicles, homes and appliances.
There’s still pent-up demand for new cars, and RVs and homes are seeing a blistering pace of sales. We can already see the effect of higher interest rates on all of these elements. Price and quantity cuts are not yet at recession levels, but auto sales are down 25% from their 2021 highs, existing home sales are down 35% from January highs and RV sales are down 36% from the same time last year.
None of this data is as bad as it seems. Some of the new car sales are hampered by ongoing supply chain issues. Home and RV sales are down from last year’s unsustainable pace. From a historical point of view, the current drop in sales is unwelcome but is not in itself a sign of a recession. Yet interest rates will continue to rise for several months, and all of this data will get worse.
Higher interest rates eventually affect small purchases as well. Consumers are rushing to pay off credit card debt, and the drop in demand for big-ticket items is spilling over to other products as well. Lower demand for housing means less purchases of appliances and furniture, while demand for auto parts and building materials will decline.
This increases the likelihood of a recession, which is likely different from our more recent experiences. We have gone through a pandemic recession which has mainly affected services. The Great Recession was led by a housing bubble, and that affected manufacturing. In 2001, we had a short, mild recession, like in 1990-91. These two downturns led to a slow recovery in the labor market that could be attributed to other causes. Next year will probably be very different.
The last recession we had as a result of Fed tightening was in 1982. This will scare many old timers, myself included, who remember the sharp drop in manufacturing. Whether or not this period of rising interest rates results in a recession, it is sure to hit the manufacturing sector harder than recent downturns.
In a typical post-World War II recession, about half of the declines in GDP were in the manufacturing sector. In the manufacturing sector, almost all of the declines were in durable consumer goods and business equipment. These purchases are more sensitive to interest rates than services and are therefore bearing the brunt of the recession. Indiana’s economy is slightly less dependent on manufacturing than in 1982, but remains the most manufacturing in the country. Indiana and the Midwest will be disproportionately hit if we enter a recession.
Whether or not we enter a recession, we should anticipate that the manufacturing sector will struggle for much of 2023. The effects are not limited to high interest rates alone. Our efforts to control inflation also mean that the US dollar is gaining value against other currencies around the world. While that’s great if you’re planning a trip to Paris or London, it also means that US exports are now more expensive than ever.
All this means that there is little chance that manufacturing production will not fall in the coming months. Yet there is also good news. Adjusting for inflation, 2021 was the highest manufacturing year in history. It’s not an industry in decline, just one that needs fewer workers to set new production records. Thus, a slowdown in manufacturing output comes just after the peak in record production.
There are other encouraging signs regarding the possible short-term effects of a recession. Since 2021, American manufacturing companies have struggled to find the workers they need. Many manufacturers, especially in the Midwest, are facing their first tight labor markets in 25 years. This will make them more reluctant to reduce employment in a downturn.
This is precisely the type of occasion in which work-sharing legislation, which allows partial layoffs, would ease the burden on employers and employees and lessen the shock of a recession. It’s no surprise that the unions and the state chamber of commerce pressed our legislature to do so. The legislator did not do this. On the bright side, this at least offers a natural experiment for economists.
The main challenge is to understand when inflation will end and how quickly changes in interest rates affect the economy. This is a mathematical relationship that economists can measure with some ease. The problem is that the relationship is constant over time. New technologies accelerate the effect of interest increases, but they also accelerate price changes for businesses. At the same time, buyers and sellers hedge risk with longer-term contracts, especially for goods that take months to produce.
Some effects of interest rate hikes will take up to 18 months to be felt in the economy, others will only take a few minutes. So by early October, perhaps two-thirds of the Fed’s interest rate hikes had yet to affect consumer spending. This explains both that inflation remains a grueling presence and why the risk of recession increases each time the Fed raises rates in response.
Once inflation reverses, the effect of interest rate increases will continue for more than a year. It is therefore almost impossible to perfectly time the level of interest rate hikes needed to slow inflation without a recession.
This is why the so-called soft landing is so rare. We shouldn’t expect one anymore, although we might be pleasantly surprised. It is more likely now that we will face a recession in the coming months. There are good signs that it won’t be deep and long, but those too can change. I don’t think an honest forecast can be made with any more certainty than that.
Michael J. Hicks is director of the Center for Business and Economic Research and the George and Frances Ball Distinguished Professor of Economics at Ball State University’s Miller College of Business. His column appears in Indiana newspapers. Send feedback to [email protected]