Economic Contraction

Is the economy good or bad? In a nutshell: Yes |

Is the economy good or bad? In a nutshell: Yes.

If recent economic headlines have given you a boost, you’re not alone. The economy has sent a lot of mixed messages. Every few days, a new report seems to give a very different impression of the current situation – and whether Americans should bask in boom times or batten down the hatches.

In fact, both accounts could be correct. There are some very good things happening in the economy, which means we’re probably not in a recession yet; but there are also extremely worrying signs suggesting that a recession may be imminent.

Last week, for example, we received another strong jobs report, which showed that 372,000 new jobs were added in June. This is a downturn from the start of the recovery, but it’s still a gangbuster number by historical standards. Thanks to an unusually fast recovery in the labor market, there are more jobs in the private sector today than before COVID-19.

Similarly, the unemployment rate, at 3.6%, is also high by historical standards. For context: there have only been three months in this century when unemployment has fallen.

Of course, that doesn’t sound like an economy in recession.

On the other hand:

Economic output – also known as gross domestic product (GDP) – shrank in the first quarter of this year, and some forecasts suggest it may have contracted again in the second quarter. Corporate profits also fell earlier this year and stock markets trended lower.

And, of course, the party’s main pain in the neck is inflation.

Inflation hit a new 40-year high in June, at 9.1% from a year earlier. Energy prices are driving much of the increase, but almost everything Americans buy has become much more expensive, including groceries and rent.

This rise in the cost of living has been extremely painful, especially for low-income households. This is the main reason why consumer sentiment just recorded its worst reading on record.

On the other hand, on the other hand:

Americans can say they’re disappointed with the economy and furious with inflation – but they don’t seem to be acting on that negativity yet. Consumer spending remained strong, even after adjusting for inflation. About a third of workers say they plan to leave their jobs this year, which is generally not a sign of low confidence in the economy.

So what about these confusing signals?

One possibility is that some of these trends will stop contradicting each other once new data comes in and past numbers are revised.

Employment figures, for example, can be subject to huge revisions, especially at times of economic downturn. Not because someone is preparing the books. It’s really hard to measure hiring patterns in real time, especially when more businesses than usual are closing or opening.

But suppose you take the latest estimates at face value. Here’s another way to reconcile at least some of these trends: the economy is overheating. This explains why the labor market is strong, why people seem confident enough to leave their current jobs and seek new opportunities, why they spend so much and why prices are rising so rapidly.

It also illustrates why recession-related worries are growing. It’s a bit counter-intuitive, but let me explain.

The standard prescription for an overheated economy is to raise interest rates in order to dampen demand. The Federal Reserve’s goal is to raise rates just enough to slow price growth, but not so much that the economy collapses. However, the worse the inflation numbers are month after month, the more aggressively the Fed needs to act.

In other words: the hotter the economy, the more cold water is needed to extinguish the flames. And the more cold water is poured, the more likely it is that the economy will completely drown.

Unfortunately, the June inflation report was torrid. The markets are anticipating increasingly steep rate hikes. In May, for example, the idea that the Fed could raise rates by three-quarters of a percentage point in a single meeting was seen as off the table. Then, inflation numbers remained uncomfortably high and the Fed finally announced a three-quarters of a percentage point hike in June.

This is the fastest rate increase in almost 30 years. At the next Fed meeting later this month, markets are expecting another hike of at least that magnitude – in fact, a full point hike now looks possible.

This is why the markets are panicking, once again. This is also why there is a growing threat of recession next year. I’m not talking about “recession” in the sense that lay people sometimes use the term to mean “something is wrong with the economy”. I mean “recession” as economists define it: a significant contraction in economic activity distributed across the economy, typically manifesting in incomes, jobs, GDP and other key metrics.

As ugly as Americans think of the economy now – while some measures still look pretty good! – the coming months could be much worse.