- A slew of data points suggest economic fundamentals are worsening and this has stoked fears of an imminent recession.
- Inversion of the yield curve has long been considered a reliable leading indicator of recession.
- Consumer confidence can’t be emphasized enough as personal spending on goods and services makes up bulk of economic activity.
- A secular decline in real income leads to a decline in overall economic activity.
Separate data released in the past week showed no let up in inflationary pressure and a further erosion in consumer confidence. After bottoming in April 2020 amid the outbreak of the Covid-19 pandemic, consumer price inflation — an indicator of a general increase in prices — began to inflect higher. It is currently hovering at the highest level in about 40 years.
As inflation began to build up, the Federal Reserve (Fed) removed its monetary policy accommodation to counter inflation. The central bank raised the Fed rates for the first time since 2018 in April to counter inflation. A higher interest rate environment looms ahead even as the economic growth hasn’t been well entrenched after the peak of Covid-19 lockdowns. The evolving scenario has the potential of pushing the economy into a condition called stagflation, which refers to a recession accompanied by a prolonged period of high inflation.
What Is a Recession?
Recession, according to the National Bureau of Economic Research, is a “period between a peak of economic activity and its subsequent trough.” The agency identifies three aspects that characterize a recession: 1) “a significant decline in economic activity,” 2) the decline is broad based and, 3) it lasts “more than a few months.”
Economic indicators, such as gross domestic product (GDP), employment, industrial production, employment, and wholesale and retail sales, give a hint as to where the economy is headed.
Technically, a recession is defined as two consecutive quarters of GDP decline. A more severe form of recession is called depression.
Against the backdrop, here are three signs for identifying a looming recession.
Yield Curve inversion
The yield curve spread, specifically the differential between the yields on the 10-year Treasury note and 3-month Treasury bill, is considered a simple and leading indicator to predict a recession, according to a research paper published by the New York Federal Reserve.
Inversion of the yield curve has historically signaled an imminent recession. This is how it works. An increase in short-term rates has the potential to slow real or inflation-adjusted growth in the near term. Secondly, the yield curve spread reflects expectations of future inflation and real interest rates.
It is evident from the chart that inversion preceded past recessions. This includes the Covid-19-induced mini-recession in 2020 and the Great Recession of 2008 that followed the housing market collapse.
Morgan Stanley’s (NYSE:MS) U.S. chief economist Ellen Zenter said in a recent report that the “yield curve has become less of a recession indicator over the last two economic cycles.”
“And when we look at factors in the economy that are typically signals of a recession, such as job growth, retail sales, real disposable income and industrial production, we don’t see an approaching recession.”
As of Jun. 13, 2022, the spread between the 10-year T-note and 3-month T-bill was a positive 1.84%.
Consumer spending is vital to keep the economy ticking, given that it makes up roughly two-thirds of the U.S. GDP growth. This metric, which helps measure how confident consumers are about current and future economic conditions, can help predict recessions.
Preliminary data released by the University of Michigan based on its consumer sentiment survey conducted in early June showed that sentiment among U.S. consumers fell to a record low of 50.2 in June from 58.4 in May. The dented confidence reflected consumer concerns over galloping inflation eroding their income and expectations of deteriorating business conditions in the year ahead.
Conference Board’s U.S. consumer confidence index, meanwhile, declined from 108.6 in April to 106.4 in May. The present situation index, which reflects consumers’ assessment of current business and labor market conditions, fell 3.3 points. The expectations index fell a more modest 1.5 points.
Real income refers to the inflation-adjusted earnings of a person. This measures the purchasing power of consumers, or in other words, how much of the consumers’ earnings are available for spending.
A decline in real income could suggest a recession is around the corner. The Bureau of Labor Statistics’ non-farm payrolls report for May showed that real average hourly earnings fell 3% year-over-year in May. This, along with the 0.9% retreat in the average workweek, led to a 3.9% drop in real average weekly earnings.
This does not come as a surprise, as inflation has been tracing an upward trajectory. The sky-high inflation in the U.S. is the handiwork of escalation in gas, food and shelter prices. The core retail consumer price inflation, which strips off the volatile food and energy prices, also came in higher than expected.
Real earnings will continue to face downward pressure as long as inflationary pressure remains uncontrolled, leaving consumers with less and less to spend.
On the date of publication, Shanthi Rexaline did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.