Why no one knows if we’re about to have a recession

The Fed is pushing the economy to the brink of recession.
Why no one knows if we’re about to have a recession
Photo by reza_arze.

Since March, the Federal Reserve has been raising interest rates in an effort to get inflation under control. At first, the Fed rate hikes didn’t seem to be having much impact. Back on June 4, the Washington Post reported that demand remained robust in many parts of the economy.

“There’s so much pent-up demand, and everybody I talk to — our suppliers and our customers — says the same,” one business owner told the Post’s David Lynch. “We’re up 40 percent over last year and climbing.”

So last month, the Fed accelerated its rate-hiking campaign, announcing its biggest one-day rate hike in 28 years.

Since then, we’ve started to see signs that the Fed’s efforts are working. Last week, the Washington Post published a story with a different tone:

U.S. flight bookings dipped 2.3 percent in May from a month earlier, according to data from Adobe Analytics. And both high- and low-income Americans have begun pulling back, particularly on services, in the past four to six weeks, according to an analysis of credit card data by Barclays.

“Consumers are still spending, but we’re also seeing a shift where they’re saying, ‘We’re going to postpone our vacation,’ or ‘Maybe I don’t need to buy a new washing machine right away,’ ” said Quincy Krosby, a strategist for LPL Financial.

Lower consumer spending will help bring down inflation. But if consumer spending slows too much, the economy will tip into recession. And this is a particularly difficult balance to strike because a significant factor driving consumer spending is whether consumers expect there to be a recession.

The direct effects of Fed interest rate hikes are fairly modest—especially now, when a lot of households have unusually healthy balance sheets. Even after the Fed’s last big rate hike, the Fed’s target rate is 1.75 percent—low by historical standards.

What makes the Fed powerful is its ability to shape expectations. In part, this works through long-term interest rates: if traders expect the Fed to continue raising short-term rates, they’ll bid up rates on longer-term debt now in anticipation of higher future rates. Higher long-term rates, in turn, tend to push down asset prices, causing people to feel poorer and hence to spend less.

Fed policies also influence consumer expectations. As rate hikes have pushed down stock prices, consumers have been getting nervous that they could lose income in a recession. Many have started tightening their belts, which means lower economy-wide spending and hence less inflation.

Indeed, when inflation is stubbornly high, as it is right now, the Fed may need to make consumers afraid of a recession. That may be the only way to convince people to trim their spending enough to get inflation under control.

Over the last few months, Fed Chairman Jerome Powell has become more pessimistic about the chances of a recession:

  • “I think it’s more likely than not that we can achieve what we call a soft landing,” Powell said back in March, as the Fed was just beginning its rate-hiking campaign.
  • By May, he was sounding more pessimistic about a soft landing, arguing that it was “quite challenging to accomplish that right now.”
  • Asked again about a soft landing in June Powell struck an even gloomier note: “​there’s no guarantee that we can do that.”

These statements may have reflected Powell’s sincerely-held views at the time he made them. But they may also reflect a growing recognition that it might be necessary to scare the public about a potential recession in order to get them to spend less.

Of course, the ideal scenario would be to scare people but then not actually have a recession. But people aren’t stupid. Recession warnings from the Fed aren’t going to scare people unless they’re accompanied by actions that actually make a recession more likely.

And this is why it’s impossible to know if a recession will happen in the coming months. To fight inflation, the Fed needs to tiptoe close to the brink of recession—so close that a lot of people think we’re going to plunge over the edge. But when you do that, there’s an inherent risk of actually falling off.

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