A look back at 2023: The recession that wasn’t.
Over my entire professional career (starting in 1977) I have not seen a downturn that was so anticipated fail to materialize – until 2023. Instead of a recession, real GDP growth is estimated to have been a solid 2.9 percent (using the Atlanta Fed’s most recent estimate of 2.3 percent for Q4 growth). Instead of monthly declines, nonfarm payroll employment averaged an increase of 189,000 per month over the first 11 months of the year – slower, but still well above trend. And instead of rising sharply, the unemployment rate was below 4.0 percent all year and was a low 3.7 percent in November.
What did the prognosticators miss? The vast majority of recession outlooks were premised on historical relationships that had a high degree of accuracy in predicting economic downturns. Most importantly, based on data for the post-WW II period, whenever the yield on the 3-month Treasury note exceeded that of the 10-year note (an inverted yield curve) for more than a month or two, recessions have always occurred within about a year (with a single exception in the mid-1960s when the Fed reversed course and quickly lowered short-term rates). This specific measure of the yield curve shape inverted in October 2022, suggesting that a downturn toward the end of this year was likely. Moreover, the magnitude of the inversion was by far the largest since at least 1982, reaching nearly 1.9 percentage points in May 2023; and this inversion has been long-lasting.
While there is no sign of a recession currently, economic activity appears to have slowed in the fourth quarter. As noted, the most recent estimate for real GDP growth is 2.3 percent – down from the third quarter’s 4.9 percent. Taking the average of October and November (to account for the UAW strike), job growth eased to an average of 174,500 – well below the average of the past 1, 2, or 3 years.
Financial markets ebbed and flowed with expectations for monetary policy changes from the Federal Reserve. After much volatility but no significant trend movement, the yield on longer-term Treasury notes rose sharply starting about mid-year as expectations for Fed easing slipped – culminating in a sell-off for the ages in October. The 10-year Treasury note yield surged by 40 basis points in just over a week, climbing to nearly 5.00 percent on October 19 – the highest level since June 2007. But signs of slower growth after that, plus market perceptions of a dovish turn by the Fed at the December FOMC meeting as inflation continued to cool, resulted in a huge rally – with the 10-year Treasury note yield down to a bit below 3.80 percent only two months later.
Equity markets generally increased until the end of July, with the S&P 500 Index up by 19.5 percent from the start of the year. Broad stock averages sold off after that, reaching a maximum decline in the S&P of 10.3 percent at the end of October – with more than half of that coming in about the last two weeks of the month. A month to forget for both stocks and bonds!
But as with bonds, stocks rallied furiously after late October, with signs of slower growth suggesting future Fed ease – an expectation reinforced at the December FOMC meeting. Going into the last week of 2023, the S&P 500 was up by 24.3 percent from the start of the year – and less than a percentage point from an all-time high.
Perhaps the most important economic data for 2023 were the sharp declines in virtually all inflation measures. The price index for personal consumption expenditures (the measure that the Fed views as the key for policy setting) ended 2022 with a 12-month trend rate of 5.4 percent (down from the cyclical high of 7.1 percent in the middle of 2022). But by November, helped by the first monthly decline in the measure since April 2020, the trend rate had fallen to 2.6 percent. Moreover, the core trend rate (excluding the volatile food and energy components) slipped to 3.2 percent. While both of these inflation readings were above the Fed’s 2.0 percent long-term goal, they were substantially closer to that goal than at any time since early 2021 and added significantly to the financial markets’ view that substantial Fed easing was near.
Our view for 2024: Choices (because nothing is ever certain in the economy).
With all of that as a precursor, what do we think will occur to the economy, inflation, and financial markets for this year? Crystal balls are rarely clear and all forecasts are conditional on certain assumptions. As a result, we will present the three most likely courses for 2024 rather than a single guess – accompanied by our subjective probabilities of occurrence.
Much of the difference in views for next year depends on whether you see the historical antecedents of recession as having broken down in this cycle. Or put another way, does the slowdown in the economy and lower inflation at end of 2023 portend a soft landing for 2024, or does the ongoing yield curve inversion suggest that it is an observation on the way from strong growth/high inflation to recession/low inflation?
Outlook #1: A modest 2024 recession (subjective probability 42 percent)
The current longevity and depth of the yield curve inversion is not atypical of the inversions that have preceded all recessions in the post-war period. While the average time from initial inversion to the start of the following recession has averaged about a year, there has been substantial variation in that timing. The current 14-month period since the inversion began is well within the historical spread. Moreover, many observers believe that monetary policy is not contractionary until the real federal funds rate turns positive. Monetary policy was so expansionary during and following the Covid-downturn and high inflation (from both supply and demand factors) that despite Fed tightening that began in March 2022, the inflation-adjusted fed funds rate didn’t turn positive until nearly a year later. In this view, Fed policy did not become actually tight until about 10 months ago. This is the recession-delayed view.
Even if the economy enters a downturn in 2024, the timing is still uncertain – but the second quarter may be the most likely for the start of a downturn. Should we anticipate another Great Financial Crisis (GFC) type downturn? Or perhaps an average recession? Or maybe even something smaller than that? The good news is that unlike in 2007, major sectors of the economy are not in severe disequilibrium. So, a deep recession appears unlikely for now (which is not to say that certain sectors of the economy – perhaps office buildings – won’t be hit hard).
Whether we end up with an average or a mild recession, we will almost certainly see the following: rising unemployment rates, lower interest rates (with the Fed easing significantly, although perhaps mostly when the recession is nearly or completely over), a drop in corporate profits, and for a time a decline in broad equity averages. Especially with a mild recession, the resulting drop in interest rates and equity markets should be at the mid-to-lower end of the scale. We would not expect anything close to the interest rate environment of 2009-10 or 2020-22 (with fed funds at zero and long-term rates at record lows).
Outlook #2: A soft landing (subjective probability 38 percent)
The unicorns of economic events, soft landings (when the economy slows to around trend growth, unemployment is mostly stable, and inflation is low and stable) are rarely achieved – at least for long. We did, of course, see long periods of relatively stable growth and inflation between the recessions of 1990-91, 2001, and 2007-09. But they were not soft-landing periods because monetary policy did not tighten significantly (i.e., cause a yield curve inversion) until late in those expansion periods, with recessions following shortly thereafter. They were not periods in which the Fed eased off of its tightening, as we anticipate for 2024. Still, the economy today appears to be in pretty good shape; inflation is falling close to the Fed’s goal; and the Fed itself anticipates easing policy next year.
What would a soft landing look like in 2024? Probably, stable unemployment (perhaps edging up a tad depending upon how much the economy cools next year), inflation falling to around the Fed’s 2.0 percent goal by the end of the year (or by early 2025), lower interest rates (mostly on the short-end of the yield curve, as long rates have already fallen substantially in anticipation of Fed easing), and probably another good year for broad equity averages (despite valuations being high historically, continued positive earnings and lower interest rates are a good environment for equities).
Outlook #3: Sticky inflation (subjective probability 12 percent)
Covid caused both supply-side and demand-side inflation. Supply chain and production problems appear to be mostly in the rear-view mirror, however, with goods prices from the PCE price index down slightly from a year ago in November. But excess demand on the services side continues to run hot, even if somewhat cooler, with services prices up by 4.1 percent from a year earlier in November. While excess savings from Covid relief have diminished over the past year or so, some still remain – keeping consumer spending stronger than it would otherwise be, even with above-trend job growth and low unemployment. Moreover, housing costs are an important element in inflation measures (in CPI more than PCE), and we have been waiting for these components to show more disinflation stemming from market-based measures of rents. Is the lag between the market-based measures just longer than usual, or is there something more fundamental occurring?
If the economy continues to grow and the job market remains tight, wage gains may also move higher (or at least maintain their current pace), making it additionally difficult for services inflation to fall significantly. And if this large component of overall inflation remains elevated, it will be difficult for overall inflation to dip back to the Fed’s 2.0 percent goal.
In this scenario, sticky inflation – keeping the overall measures higher than expected – would weigh on the Fed’s decisions to ease monetary policy. While we view this as a much lower probability event than a recession or a soft landing, the odds are not de minimis. Not only would the Fed ease by less than expected, but it might also not ease at all (and could even engage in some additional tightening). With long-term rates having fallen sharply in recent months with market expectations of significant Fed easing, this could cause a meaningful backup in rates. The outlook for equities is more difficult, as higher prices and continued economic growth would be positive for earnings. Offsetting this would be a higher interest-rate environment than the market expects.
Outlook #4: Everything else (subjective probability 8 percent)
A bonus outlook! Since the subjective probabilities of the three most likely scenarios don’t add up to 100 percent, this is a catch-all category that would include, for example, a more severe recession, a growth recession (slightly positive growth, but so slight it feels like a downturn with unemployment rising), and boosts to either the supply or demand sides of the economy (the former positive for inflation, the latter negative) that would allow the economy to reaccelerate rather than slow (or go negative). Plus, anything else that would have a low probability of occurrence.
David W. Berson, Ph.D.
Chief US Economist
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