RECESSION EMERGES AS THE MOST LIKE SCENARIO

Authors

Eric Thompson, University of Nebraska at LincolnFollow

Date of this Version

12-2022

Comments

Copyright 2022 University of Nebraska, Bureau of Business Research

Abstract

The U.S. economy faces the prospect of a second recession as the Federal Reserve Bank continues to raise interest rates to confront inflationary forces. These forces include elevated asset prices and a wage-price spiral. Further interest rate increases are likely given a challenging environment to reduce inflation. Challenges include limited migration and a slow-growing labor force, trade restrictions, regulatory restrictions that limit energy production and raise the minimum wage as well as excessive federal government spending. Federal spending through the CARES Act, Coronavirus Supplemental Appropriations Act, American Rescue Plan, and Infrastructure Investment and Jobs Act continue to fuel excess demand. Sharp increases in interest rates can slow demand in multiple ways. Higher interest rates reduce asset prices. This already has been observed in financial markets and is spreading to property markets. Companies with falling stock prices may turn to cost-cutting in terms of payroll and investment. Falling stock portfolios and declining house prices will induce households to save more and spend less out of their current income. High interest rates also lead to higher interest payments on credit cards, which reduces spending out of current income, including demand for home building and durable goods. Higher interest rates also contribute to an increase in the value of the U.S. dollar, which creates competitive challenges for U.S. businesses that compete in international markets. Manufacturers and farmers are good examples. These forces typically work with a policy lag of several quarters so recent and expected interest rate increases will impact the economy in 2023. GDP and employment growth will slow significantly, and most likely contract, throwing the economy into recession. The likelihood and depth of the recession will depend on how much the Federal Reserve Bank must raise interest rates. One key factor may be the property market. Rapid growth in rents has been a key component of high inflation. Home values and consumer demand must fall fast enough to halt or reverse the growth of rents. Another key factor will be how fervently businesses hold on to workers in the face of falling demand. Hiring has been very difficult in recent years, which may encourage businesses to hoard labor. If rent inflation subsides quickly and layoffs are moderate, interest rate increases and the 2023 recession may be less severe. A recession might even be avoided. The 2023 recession will be more severe if rent inflation remains stubbornly high. The most likely outcome is a recession in 2023. Real GDP is expected to decline by 0.3% in 2023 as a whole, with a sharper contraction in some individual quarters. Real GDP growth will recover to 1.2% for 2024 as a whole and normalize to 2.1% in 2025. Employment will fall by 0.8% in 2023 nationwide but rise by 0.2% in 2024 and 1.0% in 2025. Inflation will remain high at 4.5% for 2023 as a whole before trending towards a 2.5% rate in 2025. The Federal Funds rate will remain elevated near 5% in 2023 before falling back towards 2.0% at the end of the forecast period.