Viewpoints

At the outset of 2023, most forecasters, even some policymakers, thought a mild recession was in store for the economy. Yet, the economy expanded at an annualized rate of 3% during the first three quarters and looks to grow somewhat slower in the fourth quarter. What happened? Here are five reasons why the economy beat the odds and did not fall into a recession in 2023.

First, the inverted Treasury yield curve was "artificial." The inversion of the yield curve in the fourth quarter of 2022 was one of the most cited reasons for the recession occurring in 2023, especially with the Fed telegraphing more official rate hikes. But yield curve inversion was a direct result of another Fed policy tool.

Before the Federal Reserve started raising official rates in March 2022, it embarked on the most extensive quantitative easing (QE) program in history, purchasing approximately $4.5 trillion of debt securities in 24 months. The primary purpose of QE is to keep long-term interest rates (one side of the yield curve measure) lower than otherwise would be the case. Some analysts estimated QE was the equivalent of 150 to 250 basis points of Fed easing. Even today, the Fed's balance sheet is approximately $3.5 trillion above when they started QE in March 2020.

Second, monetary policy was not restrictive. Monetary policy influences the growth of nominal spending. At the end of Q3 2023, nominal GDP growth of 6.3% of the past year was still 100 basis points over the fed funds rate level. There has never been a recession in the past 50 years in which the level of federal funds did not equal or exceed the growth in nominal GDP.

Third, interest-sensitive sectors grew in 2023. The goods and structures sectors expanded each quarter in 2023, hitting a new record high in Q3, with an annualized growth rate of 6.9% and 3% in the past twelve months. If the economy were to enter or be in a recession, it would be most visible in these two sectors as they have consistently contracted during recession periods.

Fourth, labor demand outpaced labor supply. In 2023, the labor market was unbalanced, with the number of job openings exceeding the number of unemployed workers. At the end of Q3 2023, there were 9.5 million job openings or 1.5 jobs for every unemployed person.

Fifth, household liquidity grew in 2023. Based on the current level of equity prices and the rally in bond yields, household direct holdings of equities, debt securities, and deposits are estimated to increase between $10 and $15 trillion in 2023. Fed tightening cycles are supposed to drain liquidity, but that did not happen in 2023.

Many of these factors are still operative for 2024. The most significant positive factors for 2024 are the need for labor and the growth in household liquidity, as both would support continued growth in consumer spending.

The wild card is what happens to official and market interest rates in 2024. If the Fed raises official rates again, market rates could quickly reverse the recent decline in yields. That would have a huge and abrupt negative impact on equity prices and household liquidity; people's equity holdings account for 55% of total liquid assets directly held.

Many factors could trigger a bad outcome in 2024. But those factors need to drain liquidity and trigger contraction in interest-sensitive sectors based on the history of recessions.

The second guesstimate by the Bureau of Economic Analysis (BEA) of Q3:2023 real Gross National PRODUCT’s annualized growth came in at 5.2%, up from the first guesstimate of 4.9%. Along with these data, the BEA reported its first guesstimate of annualized growth in real Gross Domestic INCOME (GDI) , 1.5%. In theory, both GDP and GDI should be the same. Both represent the value of goods and services produced in the economy. GDP calculates this value by adding up the value of expenditures in the economy – personal consumption, business expenditures, including the change in inventories, government expenditures and the change in net exports. Income is earned by some entities for the production of goods and services. So, GDI is the sum of wages, profits, interest income, rental income and taxes minus production/import subsidies.

As I mentioned above, in theory, real GDP and real GDI should be the same. But, in practice, they are not. Plotted in Chart 1 are the quarterly observations of the year-over-year percent changes in real GDI (blue line) and real GDP (red line) from 2010 through Q3:2023. Also plotted in Chart 1 are the quarterly observations of the percentage point differences between the year-over-year percent changes in real GDI and real GDP (the green bars). Notice that in the three quarters ended Q3:2023, these differences have widened out considerably, widened out to the negative side. The median difference from Q1:2010 through Q4:2022 has been 0.09 percentage points. That’s close enough for government work for saying real GDI and real GDP, as separately calculated, are the same. But in the four quarters ended Q3:2023, the median difference has been negative 1.97 percentage points. In Q3:2023 by itself, the difference between the year-over-year percent change in real GDI and real GDP was minus 3.16 percentage points, the widest absolute difference between changes in real GDI and real GDP in the period staring in Q1:2010 through Q3:2023. Granted, the real GDI data point for Q3:2023 is the BEA’s first guestimate of it.

I don’t have access to the Blue Chip survey of economists’ forecasts of various economic data anymore, so I can’t answer my question. But I do have access to consumers’ inflation forecasts and these forecasts are terrible. Plotted in the chart below are monthly observations of consumers’ forecasts of year-ahead inflation as reported in the University of Michigan Consumer Sentiment Survey (the blue bars). Also plotted in the chart are monthly observations of the actual (until revised) year-over-year percent changes in the All-Items Consumer Price Index (the red line). The CPI percent changes are lagged such that they line up with month in which the consumers’ forecasts were surveyed. For example, in May 2020, consumers were forecasting that the year-over-year inflation rate in May 2021 would be 3.2% (the height of the blue bar in May 2020). As luck would have it, the actual CPI inflation rate turned out to be 4.9% (the height of the red line in May 2020). In October 2022, consumers were forecasting that the year-over-year inflation rate in October 2023 would be 5.0%. In fact, it turned out to be 3.2%. In the latest November survey, consumers are forecasting that inflation will be 4.5% in the 12 months ahead. Given that the sum of the monetary base plus commercial bank credit grew by only 0.7% in the 12 months ended October 2023, my bet is that the year-over-year percent change in the CPI in November 2024 will be much lower than 5.0%.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in October were quite mixed, with the balance tilting toward weakness. A full 32 states show declines from September, with West Virginia’s reading down by 1 percent and Montana’s and Mississippi’s indexes falling more than .5 percent. Of the 18 states with increases, the largest was Nevada’s fairly moderate .33 percent. Over the 3 months ending in October, 16 states had declines, with West Virginia off 2.7 percent, and Montana and Mississippi dropping more than 1 percent. South Carolina and Maryland both increased roughly 1.3 percent over this period, which is not an especially large gain for states at the top Over the last 12 months Maryland had an impressive 7.4 percent increase, and Massachusetts and Vermont were up more than 6 percent. 3 states had increases of less than 1 percent, with New Jersey again at the bottom with a .2 percent reading.

The independently estimated national figures of growth over the last 3 months (.5 percent) and 12 months (3.0 percent) both look to be roughly in line with what the state figures suggest.

Part un was written by me way back on March 14, 2020. I should have paid more attention to my 2020 commentary so that I would not have thought that household spending would be less resilient as it has been so far in 2023. Moreover, I would not have called for a recession to commence in Q2:2023.

In Chart 1 below are plotted monthly observations of the M2 money supply as a percent of nominal Disposable Personal Income (DPI). From January 2015 through December 2019, the median value of this ratio was 91.8%. Then, after the federal government started writing Covid-aid checks to households and businesses, checks financed by the Fed and banking system, the ratio of M2 to DPI reached a high of 118.9% in January 2022. As of September 2023, the ratio had declined to 102.1%, much below its January 2022 high, but also materially above its 2015-2019 median value.

State labor markets were soft in October. Florida’s 28,400 increase (.3 percent) was the only statistically significant change in payrolls (California’s 40,200 gain was not seen as statistically significant). The number of states reporting point declines was comparable to the number reporting increases. The sum of the states’ payroll changes was only 43,800 (noticeably smaller than the national 150,000), the lowest such figure since December 2020.

26 states had statistically significant increases in their unemployment rates in October, though none were larger than .2 percentage point. Nevada continued to have the nation’s highest rate, at 5.4 percent while DC was at 5.0 percent. No other state had a rate more than 1 percentage point above the nation’s 3.9 percent, though California, Illinois, and New Jersey were higher than 4.5 percent. Alabama, Florida, Hawaii, Kansas, Maine, Maryland, Massachusetts, Montana, Nebraska, New Hampshire, North Dakota, Rhode Island, South Carolina, South Dakota, Utah, Vermont, Virginia, and Wyoming, all had rates at or below 2.9 percent, with Maryland at 1.7 percent.

Puerto Rico’s unemployment rate fell t0 5.8 percent, and the island’s payrolls increased 2,800.

Monetary policy influences nominal spending in the economy. In the third quarter, nominal GDP grew 8.6% annualized. So far, in 2023, nominal GDP is running at an annualized pace of 6%. That follows a 10.6% gain in 2021 and a 9.1% gain in 2022. The three-year increase, 2021 to 2023, represents the fastest three-year advance in nominal GDP since the mid-1980s.

The economy's nominal growth performance has two critical messages/implications for policymakers and analysts/portfolio managers regarding Fed policy and market rates.

First, except for the non-economic slowdown following the pandemic, it has taken a Fed funds rate equal to or above the growth in nominal GDP to engineer a sustained growth slowdown/recession. The target on the Fed Funds rate is still 75 basis points below the growth in nominal GDP.

Second, many analysts and portfolio managers still expect a return soon to the interest rate pattern of 2008 to 2020. Yet, that interest rate pattern was abnormal, as was the nominal growth path in the economy. Only once did nominal GDP grow more than 5% during those twelve years, which occurred in 2018. The average gain was about 4%.

The interest rate pattern more applicable to the economy's current growth performance and policymakers' intent to lower inflation is from the mid-1980s to the mid-1990s. At the start of that period, the Fed funds rate, as did the 10-year Treasury yield, exceeded the Nominal GDP growth. Then, in the later part, nominal growth and nominal rates were more in line with one another.

The longer it takes the Fed to adjust policy to the current growth dynamics, the longer it will be before the economy slows and market rates fall.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in September were again soft, and the results were very similar to August’s. 19 states show declines from August, with West Virginia down nearly 1 percent. The largest increase was .65 percent in Maryland.in the rate of growth. Over the 3 months ending in September 10 states had declines, with West Virginia’s -2.2 percent the largest, while Montana was also down more than 1 percent. Maryland had the largest gain, at 2.25 percent. The results are less lackluster at the 12-month horizon, with Maryland up 7.8 percent and Massachusetts and Vermont both up more than 6 percent.. 3 states had increases of less than 1 percent, with New Jersey up a mere .20 percent.

The independently estimated national figures of growth over the last 3 months (.7 percent) and 12 months (3.1 percent) both look to be roughly in line with what the state figures suggest.