Why everyone thinks a recession is coming in 2023

People who have lost their jobs wait in line to file for unemployment following an outbreak of the coronavirus disease (COVID-19), at an Arkansas Workforce Center in Fort Smith, Arkansas, U.S., April 6, 2020.

Nick Oxford| File Photo | REUTERS

Recessions often come as a surprise to everyone. Chances are the next one won’t.

Economists have been predicting a recession for months and most see it starting early next year. Whether deep or shallow, long or short is up for debate, but the idea that the economy is entering a period of contraction is more or less the consensus among economists.

“When you have high inflation and the Fed raises rates to quell inflation, it historically results in a downturn or recession,” said Mark Zandi, chief economist at Moody’s Analytics. “It invariably happens — the classic overheating scenario leading to a recession. We’ve seen this story before. When inflation picks up and the Fed responds by raising interest rates, the economy eventually collapses under the weight of higher interest rates.”

Zandi is among the minority of economists who believe the Federal Reserve can avoid a recession by raising interest rates just long enough to avoid stifling growth. But he said expectations are high that the economy will slump.

“Most of the time, recessions creep up on us. CEOs never talk about recessions,” says Zandi. “Now it seems CEOs are falling over themselves to say we’re going into a recession. … Everyone on TV says recession. Every economist says recession. I’ve never seen anything like it.”

Fed caused it this time

Ironically, the Fed is slowing the economy, having come to the rescue in the last two economic downturns. The central bank helped boost lending by driving interest rates to zero, and increased market liquidity by adding trillions of dollars in assets to its balance sheet. It is now unwinding that balance and has quickly raised rates from zero in March to a range of 4.25% to 4.5% this month.

But in those last two recessions, policymakers didn’t have to worry about high inflation eating away at consumers’ or businesses’ purchasing power, seeping through the economy through the supply chain and rising wages.

The Fed is now in a serious battle with inflation. It predicts additional rate hikes, to about 5.1% early next year, and economists expect it to maintain those high rates to keep inflation in check.

Those higher rates are already taking their toll on the housing market, with home sales falling 35.4% year-on-year in November, the 10th straight month of decline. The 30-year mortgage rate is close to 7%. And consumer inflation was still a hot 7.1% year on year in November.

“You need to blow the dust off your economics book. This is going to be a classic recession,” said Tom Simons, money market economist at Jefferies. “The transmission mechanism that we’re going to see working first early next year, we’re going to start seeing significant margin compression in corporate earnings. Once that starts working, they’re going to take steps to change the first place we’re going to see is to reduce headcount. We’ll see that by the middle of next year, and then we’ll see economic growth slow down significantly and inflation will come down as well.”

How bad will it be?

A recession is considered a prolonged economic downturn that largely affects the economy and typically lasts two quarters or more. The National Bureau of Economic Research, the arbiter of recessions, is considering how deep the slowdown is, how widespread it is and how long it will last.

However, if one factor is severe enough, the NBER may declare a recession. For example, the downturn of the 2020 pandemic was so sudden and sharp with far-reaching consequences that it was determined to become a recession, even if it was very short-lived.

“I’m hoping for a short, shallow one, but hope is eternal,” said Diane Swonk, chief economist at KPMG. “The good news is we should be able to recover from it quickly. We have good balance sheets and you should see a response to lower rates once the Fed starts easing. Fed-induced recessions are not balance sheet recessions.”

The Federal Reserve’s latest economic projections show the economy growing at 0.5% in 2023, with no recession forecast.

“We will have one because the Fed is trying to create one,” Swonk said. “If you say that growth will flatten to zero and the unemployment rate will rise… then it is clear that the Fed has a recession in its forecast, but they will not say it.” The central bank predicts that unemployment could rise from 3.7% now to 4.6% next year.

Fed reversal?

It is unclear how long policymakers can keep interest rates at a high level. Futures traders expect the Fed to begin rate cuts in late 2023. In its own forecast, the central bank indicates interest rate cuts from 2024.

Swonk thinks the Fed will have to fall back on higher interest rates at some point because of the recession, but Simons expects a recession could last until late 2024 in a period of high interest rates.

“The market clearly thinks the Fed will change the course of interest rates if things fall,” Simons said. “What is not appreciated is that the Fed needs this to maintain its long-term inflation credibility.”

The last two recessions came after shocks. The 2008 recession started in the financial system, and the upcoming recession won’t be like that, Simons said.

“It became practically impossible to borrow money, even though interest rates were low, the flow of credit slowed down a lot. Mortgage markets were broken. Financial markets suffered from the contagion of derivatives,” said Simons. “It was financially generated. It wasn’t so much the Fed’s tightening policy by raising interest rates, but the market was closing down due to a lack of liquidity and confidence. I don’t think we have that now.”

That recession lasted longer than it seemed in retrospect, Swonk said. “It started in January 2008. … It lasted about a year and a half,” she said. “We had a year where you didn’t realize you were in it, but technically you did. … The pandemic recession lasted two months, March, April 2020. That’s all.”

While the potential for a recession has been on the horizon for some time, the Fed has so far failed to really put the brakes on employment and cool the economy through the labor market. But layoff announcements are piling up, and some economists see the potential for a fall in employment next year.

“We got 600,000 at the beginning of the year [new jobs] per month, and now we get about 250,000,” Zandi said.” I think we’ll see 100,000 and next year it will basically go to zero. … That’s not enough to trigger a recession, but enough to cool the job market.” He said there could be a drop in employment next year.

“The irony here is that everyone expects a recession,” he said. That could change their behavior, the economy could cool, and the Fed shouldn’t tighten so much as to choke the economy, he said.

“Debt has never been lower, households have a boatload of cash, companies have good balance sheets, profit margins have rolled over, but they are close to record highs,” Zandi said. “The banking system has never been more well capitalized or more liquid. Every state has a rain fund. The housing market is underdeveloped. It is usually overbuilt to enter a recession. …The fundamentals of the economy look strong .”

But Swonk said policymakers will not give up on inflation until they believe they are winning. “When you see this aggressive Fed, it’s harder to argue for a soft landing, and I think that’s because the better things are, the more aggressive they have to be. It means a more active Fed,” she said.

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