Explanation: How do we know a recession has started? | Economic news
WASHINGTON — It became harder to tell whether the U.S. economy was headed for a recession on Friday when a report showed employers hired hundreds of thousands more workers last month than expected.
The astonishing strength made it clear that a pillar of the economy remains strong. That’s even though inflation is at its worst pace in 40 years, the economy’s output declined in the first half and rising interest rates are weighing on housing and other industries. All of these confusing numbers only complicate the long-term outlook for the economy.
On the one hand, two consecutive quarters of economic contraction is a long-held, albeit informal, definition of a recession. This would mark a rapid turnaround just two years after the pandemic recession officially ended. Yet, can a recession really happen when so many people still have jobs and earn more money?
It’s the latest puzzle over an economy that has baffled Federal Reserve policymakers and many economists since growth stalled in March 2020 when COVID-19 hit and 20 million Americans were suddenly fired.
While most economists – and Fed Chairman Jerome Powell – have said they don’t believe the economy is currently in a recession, with Friday’s data confirming the case for many, expectations are still high for an economic downturn begins later this year or next.
Friday’s jobs report could actually increase the odds of a recession, as it could encourage the Federal Reserve to remain aggressive in raising interest rates in order to bring down inflation. Higher rates are slowing the economy by making it more expensive to buy homes, cars and things bought with credit cards, and the Fed is raising rates at the fastest rate since the early 1980s.
Perhaps even more important than whether a recession occurs is whether workers’ paychecks are catching up with inflation. So far, average wage gains have not increased, and the pain is disproportionately hitting low-income households and black and Hispanic households. As a result, Americans increasingly soured on the economy.
This is perhaps what moves more people in November’s midterm elections than whether or not a recession has officially begun.
So how do we know exactly when an economy is in recession? Here are some answers to these questions:
Who decides when a recession starts?
Recessions are officially declared by the obscure National Bureau of Economic Research, a group of economists whose Business Cycle Dating Committee defines a recession as “a significant decline in economic activity that spreads through the economy and lasts more than a few months”.
The committee views hiring trends as a key metric in determining recessions. It also assesses many other data points, including indicators of income, employment, inflation-adjusted spending, retail sales, and industrial production. It places great emphasis on jobs and an inflation-adjusted income gauge that excludes government support payments such as Social Security.
Yet the NBER typically doesn’t declare a recession until well after it begins, sometimes up to a year. Economists consider a half-point rise in the unemployment rate, averaged over several months, to be the historically most reliable sign of a slowdown. The latest jobs report on Friday showed the unemployment rate hit its lowest level in more than 50 years.
Are two consecutive quarters of economic contraction equivalent to a recession?
It’s a general rule, but it’s not an official definition.
Yet in the past it has been a useful measure. Michael Strain, an economist at the right-wing American Enterprise Institute, notes that in each of the last 10 times the economy has contracted for two consecutive quarters, a recession has ensued.
Yet even Strain isn’t sure we’re in a recession now. Like many economists, he notes that the underlying drivers of the economy – consumer spending, business investment, home purchases – all rose in the first quarter.
Overall gross domestic product – the country’s broadest measure of output – fell at an annual rate of 1.6% from January to March due to one-off factors, including a sharp increase in imports and a drop in inventories of businesses after the holidays. Many economists expect that when GDP is revised later this year, the first quarter may even turn out positive.
“The basic story is that the economy is growing but still slowing, and that slowdown really accelerated in the second quarter,” Strain said.
Don’t many people think a recession is coming?
Yes, because many people now feel more financially burdened. With wage gains below inflation for most people, rising prices for essentials such as gas, food and rent have eroded Americans’ purchasing power,
Walmart recently reported that rising gas and food prices have forced customers to cut back on purchases of discretionary spending such as new clothes, a clear sign that consumer spending, a key driver of the economy, is s weaken. The nation’s largest retailer, Walmart, cut its profit outlook and said it will have to cut more items like furniture and electronics.
And the Fed’s rate hikes nearly doubled average mortgage rates to 4.99%, causing a sharp drop in home sales and construction.
Higher rates will also likely weigh on companies’ willingness to invest in new buildings, machinery and other equipment. If companies reduce spending and investment, they will also start to slow down hiring. The growing caution of companies to spend freely could eventually lead to layoffs. If the economy were to lose jobs and the public grew increasingly fearful, consumers would cut spending further.
The Fed’s rapid rate hikes have raised the likelihood of a recession in the next two years to nearly 50%, Goldman Sachs economists said. And Bank of America economists are now forecasting a “mild” recession later this year, while Deutsche Bank expects a recession early next year.
What are the signs of an impending recession?
According to economists, the clearest signal that a recession is underway would be a steady increase in job losses and rising unemployment. In the past, an increase in the unemployment rate of three tenths of a percentage point, averaged over the previous three months, meant that a recession would soon follow.
Many economists monitor the number of people filing for unemployment benefits each week, which indicates whether the layoffs are getting worse. Weekly jobless claims, averaged over the past four weeks, have been rising recently and topped 250,000. While this is a potentially worrying sign, it is still a low historically low.
Other signals to watch out for?
Many economists also watch changes in interest payments, or yields, on different bonds for a signal of recession known as an “inverted yield curve.” This happens when the yield on the 10-year Treasury falls below the yield on a short-term Treasury, such as the 3-month Treasury bill. It’s unusual. Normally, longer-term bonds offer investors a higher return in exchange for tying up their money for a longer period.
Inverted yield curves usually mean investors are anticipating a recession that will force the Fed to cut rates. Inverted curves often predate recessions. Yet, it can take 18-24 months for a downturn to occur after the yield curve inverts.
For weeks, the two-year Treasury yield has exceeded the 10-year yield, suggesting markets are expecting a recession to come. Many analysts say, however, that comparing the 3-month yield to the 10-year yield has a better record when it comes to predicting recession. These rates are not reversed now, although the gap has narrowed.
Will the Fed keep raising rates even as the economy slows?
Flashing signals from the economy – slowing growth with strong hiring – put the Fed in a difficult position. Chairman Jerome Powell is aiming for a “soft landing,” in which the economy weakens enough to slow hiring and wage growth without causing a recession and bringing inflation back to the Fed’s 2% target.
But Powell acknowledged that such a result has become more difficult to achieve. Russia’s invasion of Ukraine and China’s COVID-19 lockdowns have driven up prices for energy foods and many US-made parts
Powell also indicated that if necessary, the Fed will continue to raise rates even in a weak economy if that is what is needed to get inflation under control.
“Is there a risk of going too far? Powell asked last month. “Yes, there is a risk, but I disagree that it is the biggest risk to the economy. The biggest mistake to make…would be not to restore price stability .”