MainStreet Macro: An economy in transition

As we round out 2022, one of the most frequent questions I get is, “Are we heading toward a recession?”

Economic downturns are notoriously hard to call in real-time. In fact, recessions aren’t officially designated until several months after the economy has moved out of one. 

What we do know right now is that we’re in an economic transition. The pandemic left a lasting imprint on the U.S. economy. And while certain segments – including housing, labor, and consumer spending – have recovered from the worst of the pandemic downturn, their DNA has been altered in perceptible ways.

As we ponder the odds of recession, the economy’s shape-shifting might prove more important than whether a downturn arrives.

Housing

Let’s start with housing. It’s one of the most interest rate-sensitive segments of the economy, and downturns in the sector historically have been a bellwether of recession.

One important way Federal Reserve monetary policy is transmitted to Main Street is through housing. As mortgage rates rise in response to Fed rate hikes, homebuyer demand cools and construction slows. 

That dynamic is different now. In past recessions, housing has been weighed down by oversupply, which slowed price appreciation as higher rates cooled homebuyer demand.

This time around, home sales have slowed, but not just because mortgage rates are higher. There also are too few houses on the market. Listings are in short supply especially for affordably priced homes. Prices still are increasing by double digits – faster than inflation.

The shortage of homes for sale means that would-be homebuyers are forced to remain renters, which could push up demand – and rents – for apartments and single-family rentals.

But the biggest challenge of higher rates is on the supply side. Costlier financing keeps builders from supplying new inventory and discourages homeowners from selling. A cheap mortgage is a valuable thing that can’t be replaced in the current market.

Given the constrained supply of properties for sale, it’s hard to make the case that the current slowdown in home sales is a bellwether of recession.

Labor

For more evidence of an economy in transition, we turn to a subject we know well – the job market.

Unemployment is a strong indicator of economic weakness. After the 2008-2009 financial crisis, the unemployment rate remained above 7 percent for five years.

The pandemic jobs recovery has been remarkably swift by comparison. Job gains this year have been robust and employment, at 3.7 percent, is near historic lows.

But those upbeat indicators aren’t all the result of employer demand. Like housing, the job market is being defined by a shortage – in this case, of workers.

Fewer people are in the labor market now compared to before the pandemic. Workers are changing employers more frequently, pursuing remote and hybrid jobs, and leaving the labor force altogether. These individual decisions, made at the micro level, have had a big impact on the macro level, leading to persistent labor shortages.

Could the unemployment rate go up next year? Yes. But how high and for how long is more difficult to determine given the altered state of a labor market that continues to favor workers more than in previous downturns.

Consumers

At the end of the day, the fate of the economy lies in the millions of consumers who will vote with their dollars on whether we’re headed towards recession.

Consumer sentiment has been looking grim of late, compared to last year.

Despite the downbeat sentiment, consumer spending is so far holding up even in the face of inflation. And while borrowing costs have gone up with each Fed rate hike, during the first half of 2022, the share of household debt to GDP was near the lowest it’s been in a decade.

Instead of spending less, households seem to be changing what they buy. Consumers are buying fewer big-ticket items, like televisions, and concentrating purchases on food, clothing, and services. 

The service sector is where the shift in consumer spending intersects with labor shortages, which are most pronounced in consumer-facing service industries. That could keep inflation in services running hot into 2023.

My Take
At the end of the day, recessions are an academic question answered by a panel of experts who examine the data in detail over a series of months.

If a recession is called next year, it will have an unusual starting point, one in which housing supply, unemployment, and consumer debt all are near historic lows.

With that unusual dynamic in mind, the question of whether the Federal Reserve achieves a soft (no recession) or hard (recession) landing next year might not be the most critical one to be asking. The kind of recession we have – if it comes – could be more important. I’ll be back after the holiday break to explore that question. Thanks for reading this year, and I wish you and yours a happy and healthy holiday season.