Is the economy at risk of a recession?

Despite persistent inflation and higher interest rates, the U.S. economy remains on a modest growth trajectory. The economy generated a 2.2% annualized growth rate in the first quarter of 2023 as measured by gross domestic product (GDP), followed by an increase of 2.1% in the second quarter.¹

This year’s results show an economy that has stabilized at a modest rate of expansion. The current level is slower than the annualized growth rate of 5.8% recorded in 2021, which represented the fastest rate of growth in a calendar year since 1984. GDP grew at a much more moderate 1.9% in 2022.¹

“The positive data we’ve seen so far this year seems to be striking down the “wall of worry” over the potential of a recession in the near term,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management.

Source: U.S. Bureau of Economic Analysis, “Real Gross Domestic Product and Related Measures: Percent Change from Preceding Period,” September 28, 2023.

“The continued strength of the consumer was a primary driver allowing the economy to maintain modestly positive growth so far this year,” says Haworth. “The job market’s strength is helping consumers maintain their spending levels.” The economy continues to benefit from very low unemployment (3.8% in August) and solid job growth.² In addition, there are significantly more job openings than there are available workers.³

The impact of inflation’s re-emergence

The re-emergence of inflation which peaked in June 2022 at more than 9% over the previous 12-month period (based on the Consumer Price Index or CPI) was the catalyst of major changes in the economy.² This was the highest level in more than four decades and exceeds by a wide margin the inflation target established by the Fed. Inflation has since slowed, and as of August 2023, stood at 3.7% over the previous 12-month period.² The Fed targets an inflation rate that averages close to 2% over time.

In response, the Fed adopted a new strategy, raising the primary interest rate it controls, the fed funds rate, for the first time since 2018. By July 2023, the Fed hiked the target fed funds rate to a range of 5.25% - 5.50%, up from near zero percent before rate hikes began. It’s the highest level for the fed funds rate since early 2001.⁴ The Fed also ended its bond buying program and reducing its bond holdings. The Fed’s goal is slow economic growth to help reduce inflationary pressures. “The Fed continues to make clear that its primary target is to soften inflation,” says Haworth. “Core inflation (living costs excluding the volatile food and energy sectors) and wage costs remain higher than the Fed’s target, and the Fed has indicated it will at least maintain higher interest rates for an extended period of time,” says Haworth.

Today’s higher interest rate environment

In response to the Fed’s aggressive interest rate hikes, yields on many types of fixed income vehicles (certificates of deposit, money market funds, bonds) rose as well. Mortgage rates and interest charged on other types of financing, such as credit card debt and automobile loans, also moved higher.

The changing interest rate environment had its greatest impact on areas of the economy such as the housing market . Activity temporarily slowed due to increasing mortgage rates, though it has stabilized in recent months. However, as home prices have recovered after a short-lived decline and 30-year mortgage rates topped 7%,⁵ housing affordability is now a bigger concern. Haworth is also watching whether consumer and business borrowing begins to slow given higher loan costs attributable to rising interest rates.

Despite the Fed tightening monetary policy since March 2022, job growth has remained solid and wages continue to grow at an annual pace of more than 4%, giving consumers the ability to maintain higher spending levels.² “What the Fed is most focused on is wage growth and its impact on the overall inflation rate,” says Haworth.

Can the economy stay on track?

A key question is whether the Fed’s aggressive interest rate policy allows it to successfully tackle the inflation threat while steering the economy toward a “soft landing” and avoiding a recession.

“It seems likely the economy may avoid a recession, but we expect that real GDP growth will remain modest in the near term,” says Matt Schoeppner, senior economist at U.S. Bank. “It might qualify as what we call a ‘growth recession,’ where we see a slow economy, but with few ramifications for the job market.” Estimates of third quarter GDP growth indicate that the economy may have actually gained some momentum over the July-to-September period. The actual number won’t be known before the first issuance of official government data on third quarter GDP, scheduled for late October.

However, recent data may signal that the Fed will feel less pressure to further tighten its monetary policy. “Somewhat softer employment eased investor concerns for future Fed rate hikes,” says Haworth. Nevertheless, members of the Federal Open Market Committee, which determines interest rate policy, indicated in September that they were open to the possibility of at least one more rate hike in 2023. Notably, expectations were set that the Fed is not likely to begin cutting the fed funds rate anytime soon.⁶

Implications for investors

Haworth is closely monitoring corporate earnings results. First and second quarter earnings growth declined, but generally outpaced expectations. Haworth says investors should stay attuned to a variety of factors that have worked in the economy’s favor to this point despite sticky inflation and higher interest rates. “Will the job market and wage growth slow, and cause consumers to pull back on spending? Will inflation become a bigger issue again? Will the Fed be more aggressive with interest rate hikes than the markets anticipate at this point?” These are key questions Haworth believes will impact whether the economy grows or contracts in the coming months.

Equity markets performed well in the first seven months of 2023, with the benchmark S&P 500 gaining more than 19%. From that point, stocks surrendered some of those gains, and the year-to-date uptick was trimmed to just 11% near the end of September.⁷ Much of the stock market’s strength in 2023 has been limited to technology stocks. Haworth expects markets to remain “choppy” in the near term but adds if the economy shows more strength in the coming months, that could work to the benefit of other sectors of the market that are more dependent on favorable economic trends.

Consider reviewing your current portfolio with your wealth management professional to determine if it’s consistent with your long-term goals and positioned to meet the challenges of what continues to be an uncertain market and economic environment.

Note: Diversification and asset allocation do not guarantee returns or protect against losses. The Standard & Poor’s 500 Index (S&P 500) consists of 500 widely traded stocks that are considered to represent the performance of the U.S. stock market in general. The S&P 500 is an unmanaged index of stocks. It is not possible to invest directly in the index. Past performance is no guarantee of future results.