The odds of the U.S. entering into a recession are declining as inflation continues to fall and the Federal Reserve pauses its rate hikes, giving consumers some breathing room. The Fed kept the Federal Funds Effective Rate unchanged on Wednesday but stated that additional rate increases are likely to occur in the second half of 2023. The stock market reacted negatively with the Dow declining by 232 points while short-term yields rose.
The central bank is still working to reduce inflation rates as FOMC participants “expect core and overall PCE inflation to gradually slow to 2 percent over the next couple of years,” said Gus Faucher, chief economist at PNC. Chairman Jerome Powell said in a post-meeting press conference that for inflation to decline to 2 percent would likely require declines in both economic growth and the labor market. The Fed does not plan to stop their rate hikes, he said.
“The committee wants to see what impacts the tightening in monetary policy that has taken place over the last couple of years as well as the tightening in financial market conditions has had and will have on the U.S. economy, labor market and inflation,” Faucher said. “But the FOMC is clearly signaling, through both the statement and the dot plot, that the fed funds rate is likely to move higher in the second half of 2023.”
Investment banks believe the odds of a recession happening in the U.S. within the next 12 months are falling. Goldman Sachs (GS) said the probability of a recession occurring has fallen to only a 25 percent chance. The bank previously said the odds were 35 percent.
The U.S. economy will maintain its growth rate although it might contract, Jan Hatzius, chief economist and head of global investment research at Goldman Sachs, told CNBC’s Squawk on the Street.
“We are in a below-trend growth environment … but positive growth still seems more likely,” Hatzius said.
Some economists believe the U.S. economy will perform well as the labor market rebounds, wages rise and inflation continues to fall. Consumers remain slightly confident in the economy despite higher mortgage rates and interest rates on loans.
“Consumer spending has been bolstered by a strong job market and rising wages, which have helped counter rising prices and higher borrowing costs,” said Jack Kleinhenz, chief economist of the National Retail Federation. The moves conducted by the Fed to slow down inflation have not thrust the economy into a recession, he said. The gross domestic product grew at an annualized rate of 1.1 percent after a revision in the first quarter compared to the original estimate of 1.3 percent. Some economists still believe the economy could enter a recession later this year.
The services sector is expanding still, but its growth is lackluster and “just barely positive,” Faucher said. “The best news in the ISM services index for May was continued growth in the forward-looking new orders subindex, although the pace of expansion slowed,” he said. “The ISM manufacturing index was in contraction at 46.9 percent in May, down from 46.9 percent in April. It has been in contraction since November 2022.”
Both the services and manufacturing ISM indices are indicating weaker and slowing, yet positive growth for mid-2023. But the declines in the two indices are not likely to stop.
“The U.S. economy is set to enter recession around the end of 2023 as the cumulative impact of higher interest rates continues to weigh on activity,” Faucher said.
The current real fed fund rate remains low compared to previous recession periods. Since the Fed will likely have to raise rates again to quell inflation, it increases the odds of a recession occurring, Mary Anderson, a Wells Fargo investment strategy analyst said in a report. In past cycles, the real federal funds rate became positive and above 1-2 percent before a recession occurred. In the past 11 rate hike cycles, the economy was able to avoid a recession taking place just three times, the report said.
The economy is weakening and it will become more apparent as tailwinds from the pandemic hiring weaken and headwinds from tightening liquidity conductions “builds further,” Anderson said. A recession could occur later in 2023 and investors should stick to defensive investments in their portfolios, she added.