Will the US avoid recession? Multiple indicators are pointing towards a soft landing. Twelve-month core inflation is on a clear downward trend, falling 2.5 percentage points from its peak in September 2022; and high household consumption has led to strong real GDP growth, of 2.9% over the last four quarters.
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With core inflation falling, the Fed kept the federal funds rate unchanged in the range between 5.25%-5.50% in its meeting on 1 November, meaning that the rate has remained at a constant level since July.
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Most US hiking cycles end in recession, between eleven months and four years after the cycle commenced. This is because the expenditure components of GDP generally fall as real interest rates increase and as inflation bears down on real incomes and real profits, leading to less economic growth. However, if the central bank is successful in anchoring future inflation expectations around the 2% target, so that inflation falls back to target without the need for further strong tightening, recession can be avoided. This type of soft landing is where the US currently seems to be headed.
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But why? The US twelve-month inflation rate peaked at 8.9% in June 2022. Historically, when inflation has been close to double digits or above, this has almost always been followed by recession. The US has not managed to avoid recession with inflation levels this high since 1951. What distinguishes the current period from history?
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One difference is that wage inflation, an important driver of consumer price inflation, is falling, despite a very tight US labour market.
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Another difference from previous hiking cycles is that US household consumption has remained high despite the cost-of-living crisis, due to US consumers eating into their pandemic savings. As can be seen from the chart below, US household savings as a share of disposable income are down 15.6 percentage points since their February 2021 peak, and are 2.3 percentage points lower than the average from 2015 to 2019. Private consumption was the main contributor to strong real GDP growth in the four quarters to 2023 Q3. If US consumers continue eating into their pandemic savings, it is therefore likely that the country will avoid recession.
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The San Francisco Fed has previously warned that US pandemic savings may run out this quarter. However, the stock of pandemic savings, both when measured with a baseline of the average over the two years to December 2019 (6.9% baseline in the chart below) or over the five years to December 2019 (6.2% baseline), is still high enough to keep up consumption for some time, especially after the recent revisions to the data on personal savings as a percentage of disposable income.
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It has been argued that the preponderance of long-term fixed interest rates on long-duration debt such as mortgages, which account for two-thirds of US household debt, increases the chances of avoiding recession because it limits the impact of monetary policy on households. Balancing this out, however, monetary policymakers then need to conduct more tightening to achieve the same amount of disinflation, limiting consumption and therefore GDP growth. As can be seen from the chart below, debt-servicing costs on non-mortgage debt have risen precipitously in the last year. The US consumer is not protected against higher rates on this component of household debt. If the US avoids recession, it will not be because of fixed-rate mortgages but because of consumers eating into their pandemic savings.
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If the Fed manages to continue keeping inflation under control without further tightening, the US may avoid recession — and the contribution of private consumption to strong GDP growth in the four quarters to 2023 Q3 points to that outcome. On the other hand, if strong private consumption leads to upward pressure on inflation, or a tight labour market leads to renewed wage inflation, further tightening may be needed. However, with the third lowest inflation rate among the G7, and wage inflation on a clear downward trend, it is most likely that the US will achieve a soft landing.
The views expressed in this article are the views of the author, not necessarily those of LSEG.
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