If the U.S. economy does tip into a recession, it will have been one of the most telegraphed events in history. The yield curve for Treasury bonds has now been inverted for months. When the yield on short-term bonds is higher than the yield on long-term bonds, it has been a very reliable indicator in the past that a recession will be declared in the next 12-18 months. At least that's how it normally works.
But nothing over the last few years of economic activity has been normal. Especially when factoring in things like the pandemic, quantitative easing, regional war in Europe, and now quantitative tightening, fiscal stimulus, and a short-lived regional banking crisis. Also, it's important to note that recessions are rarely caused by the same dynamics.
Given all this uniqueness, is it possible that the U.S. does avoid a seemingly obvious imminent recession? It very well might be, according to U.S. Treasury Secretary Janet Yellen.
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A resilient economy
Yellen's belief that the U.S. economy can sidestep a recession stems from the idea that the economy, by and large, has remained strong amidst all this uncertainty.
"My odds of [a recession], if anything, have gone down -- because look at the resilience of the labor market, and inflation is coming down," Yellen told Bloomberg News recently. Yellen wouldn't go so far as to say it's not a risk. She knows that the Federal Reserve's various money-tightening policies (including rate hikes) are slowing things down. And yet, in May, the unemployment rate was 3.7% and the economy continued to add more jobs than expected.
The Federal Reserve's massive interest rate hiking campaign, which has jacked rates up from practically zero to now float just above 5%, has managed to bring down inflation significantly. The Consumer Price Index, which tracks the prices on a market basket of consumer goods and services, peaked around 9% in mid-2022 but was back down to 4% in May. Still, core inflation (which excluding food and energy) is 5.3%, indicating that inflation is still high and well above the Fed's preferred 2% target.
While more positive than most, Yellen acknowledged that lowering inflation would not be pain-free. The former Federal Reserve chair admitted the U.S. probably needs to see some slowdown in spending in order to get inflation down to target rates.
The Federal Reserve still seems to be worried about inflation, indicating at its most recent meeting that it expects to need to raise interest rates twice more in 2023. Such statements suggest they agree with Yellen that the economy is still quite strong. It appears the markets currently expect the Fed to only raise rates one more time, with interest rates ending the year a quarter-point higher than they currently stand.
Still up in the air
It remains to be seen what the U.S. economy has in store for the rest of the year.
On one hand, the economy does seem strong and resilient right now. On the other, the Fed has raised interest rates incredibly quickly, much quicker than they would under more normal circumstances. It usually takes time for rate hikes to work their way through the economy, so it's quite possible that there is a much larger impact still to come. This may indeed bring down inflation, but also tip the economy into a recession.
As mentioned, recessions rarely have the same causes and effects, and the last few years have been like nothing we have ever seen before. Perhaps Yellen is right, and despite all the warning signs, the economy ends up avoiding a recession. But that's still far from a guarantee.
Investors still need to stay vigilant and be ready for any number of outcomes, both positive and not-so-positive.
