Will it be a recession or a soft landing? Pay attention to these indicators

A growing number of economists who had been forecasting a recession now believe the U.S. can achieve a “soft landing,” or a gradual slowdown in growth that avoids a downturn.

Economists say there’s a 50% chance of a recession in the next 12 months, down from 56% in July and 61% in May, according to a survey by Wolters Kluwer Blue Chip Economic Indicators conducted early this week and scheduled to be released Friday.  

Behind their brighter outlook is an economy that continues to churn out sturdy growth despite the Federal Reserve’s sharpest flurry of interest rate hikes in four decades, combined with a more dramatic pullback in inflation recently. The latter lowers the odds of additional Fed rate increases that likely would dampen economic activity in a bid to further tame inflation.

“The economy hasn’t really meaningfully decelerated,” says Aditya Bhave, senior U.S. economist at Bank of America, citing a recent pickup in consumer and business spending.

Like some other research firms, Bank of America recently upgraded its outlook and no longer predicts a mild recession will begin the first half of next year.

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Other forecasters say the optimists mistakenly believe persistently sunny weather means a storm isn’t eventually coming. In other words, the Fed’s aggressive rate increases will take a bigger toll.

 “The soft landing crowd - they’re looking at backwards-looking figures,” says Bob Schwartz, senior economist at Oxford Economics, which continues to project a modest recession late this year or in early 2024.

Here’s a look at arguments for and against a soft landing.

Reasons the U.S. could dodge an economic slump:

A still solid economy

The U.S. economy expanded at a better-than-expected 2.4% annual rate in the second quarter and has averaged 2.6% growth since the middle of last year.

Most of the growth isn’t because of quirky changes in trade and business inventories. Rather, the economy’s main engines – consumer and business spending – are still humming, That means the economy has some momentum that should have ripple effects going forward. For example, if consumers and companies are making more purchases, manufacturers and retailers need to hire more employees in the months ahead, which should further boost income and spending.

Easing inflation

Annual inflation has been moderating, clocking in at 3.2% in July, down from 9.1% in June 2022. As a result, many economists think the Fed will hold interest rates steady after lifting them by 5.25 percentage points in 16 months. That should reduce the risk of a downturn.

Healthy consumer spending

Consumption, which makes up about 70% of economic activity, rose at a 1.6% annualized rate in the April-June quarter, down from 4.2% early this year but that’s still a decent pace. And spending rose a robust 0.5% in June, government figures show.

Economists have expected household spending to tumble as Americans deplete their pandemic-related savings from stimulus checks and hunkering down in the early days of the health crisis.  

But incomes are still strong amid persistent COVID-induced worker shortages. Annual wage growth for private-sector workers slowed to 4.6% in the second quarter from 5.7% a year earlier but that’s still well above the 3% pre-pandemic pace. More critically, pay increases have outpaced inflation in recent months, giving shoppers more purchasing power.

Americans’ pent-up demand for travel, dining out and other activities has begun to wane. But many people working from home at least some of the time have returned to snapping up durable goods such as cars, TVs, furniture and computers, as they did early in the pandemic, Bhave says.

And now that supply chain troubles have largely resolved, making more cars available, U.S. vehicle sales have taken off. Bhave estimates there’s pent-up demand for 6.6 million auto sales. The purchases are more than offsetting any reduced sales due to higher interest rates on car loans.

Business investment rebound

Business outlays rose 7.7% in the second quarter after nearly flatlining early this year. Higher interest rates have been expected to curtail big-ticket business purchases such as factory machines. Bhave partly traces the rebound to the CHIPs and Science Act of 2022, which provides $52 billion in federal funding for semiconductor research and production and has spurred a wave of private investment.

Slower but steady job growth

Average monthly job gains have slowed to 218,000 from May through July from 317,000 in the first quarter. But economists expected more of a pullback in light of higher borrowing costs.

One reason net job gains have held up is employers have been reluctant to lay off workers amid longstanding labor shortages, economists say. A recession is unlikely without a big increase in layoffs.

Other federal spending

Besides the CHIPS Act, the Infrastructure Investment and Jobs Act and the Inflation Reduction Act set aside nearly $2 trillion to improve highways, broadband and clean energy production, among other projects. The measures should modestly support economic growth next year, Bhave says.

Manufacturing and housing have stabilized

Both the manufacturing and housing industries have contracted since last year amid higher interest rates. But both sectors seem to have hit bottom, Bhave says.

Housing starts bounced back recently as high mortgage rates discourage homeowners from moving up to larger houses, limiting existing home inventories and spurring new construction.

Reasons the U.S. could still be hit by a recession:

Delayed effects of rate hikes

Legendary economist Milton Friedman once said Fed rate increases effect the economy with “long and variable lags.” In other words, it could take a year or two before the higher borrowing costs work their way into the economy. Consumer and business spending may still be chugging along but they’ll peter out at some point, Oxford's Schwartz says.

“Our view is the lagged effects haven’t kicked in yet,” he says. He expects to see a bigger impact by early next year, with a scaleback in both consumer and business spending and a rise in layoffs.

The Fed may not be done

Although inflation has moderated, many economists say labor shortages and strong wage growth will lead the Fed to raise rates again this year to stamp out price increases on a more sustainable basis.

Barclays expects another rate hike in November. And that could contribute to tipping the economy into recession, says Jonathan Millar, Barclays’ senior U.S. economist.

Stricter lending

Lending criteria have tightened this year amid the collapse of Silicon Valley Bank and other regional banks as well as the Fed’s rate hikes. Moody's said this week it's downgrading the credit ratings of 10 small to midsize banks.

Late last month, banks reported a further toughening in lending criteria and reduced loan demand. As with the rate hikes, the effects of the lending constraints haven’t significantly affected the economy but they will, Schwartz says.

Higher gas prices

The global economy has been more resilient than anticipated in the face of central bank interest rate increases. That has started pushing up global oil prices and U.S. gasoline prices have followed, with average pump costs climbing to $3.62 a gallon in July, Oxford says. That likely will reduce consumer spending in coming months, the research firm says.

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New pressures on consumer spending

Although consumption has held up so far, other forces will likely start to have a bigger impact, Schwartz says.

Excess pandemic-related savings is down to about $400 billion from a peak of $3 trillion, he says, and low- and middle-income Americans will soon deplete any remaining cash reserves.

Also, student loan repayments suspended during the pandemic are set to resume in September, crimping disposable income and spending for millions of borrowers.

The payments could shave about a quarter percentage point off economic growth over the next year, Moody’s Analytics estimates.