Summary
- While both long and most short leading indicators have turned negative, no recession has materialized yet, and in January a number of metrics showed renewed strength.
- There are three primary reasons why most coincident indicators haven’t rolled over yet.
- These include a big decline in energy prices, a logjam in the transmission of rate hikes through the housing sector, and a continued shortfall in employees vs. consumer purchases.
- Until at least two of these roll over - which likely will happen in the very near future - it is very unlikely a recession will actually start.
Introduction
For the past year, almost the entire slate of long leading indicators has been negative. They were joined by a majority of the short leading indicators by last autumn. So here we are, verging on spring, and not only has no recession materialized, but the latest readings of several of the coincident indicators used by the NBER to gauge such events - employment, real income less government transfers, and real sales - were particularly strong.
This seeming quandary has led even some economic “big guns” like Paul Krugman to write , “our big prediction problems now [ ] involve … aggregate demand. Why is spending so resilient?”
The three big reasons the economy remains positive
So why isn’t there any indication that the economy is heading south? There are 3 big reasons.
1. A 40% decline in gas and oil prices can work wonders for inflation adjusted data
Between November 2021 and June 2022, oil prices increased about 70% from roughly $70/barrel to $120/barrel. Since then they have declined almost all the way back, recently in a range between $75-$80/barrel. Similarly, gas prices increased over 50% from $3.20/gallon to $5/gallon until last June. Since then, they have declined back to a range between $3-$3.40/gallon:
A consumer with a 20 gallon fuel tank had to pay $100 to fill it last June. Now that is down around $65, leaving $35 to be saved or spent on other things. And the money isn’t going overseas to OPEC producers or to a few large energy companies, but is being spread over a wide array of other goods and services.
Unsurprisingly, things like real personal income and real manufacturing trade sales, two series relied upon by the NBER, which declined in the first half of 2022, have shot back up:
It’s hard to start a recession when consumers and producers just got a real increase in spending money.
2. The Fed’s transmission mechanism through housing has a logjam
One of the major ways that Fed rate hikes get injected into the economy is via the important housing sector. A big increase in interest rates leads to a big decrease in housing permits and starts - which has indeed happened:
But the *real* economic impact of the housing market is via construction. More or less construction means more or less money injected into a wide variety of trades. And housing units under construction tend to follow permits with a variable delay from only a month or two to many months later.
And this time around, units under construction continued to make new all time records until just a couple of months ago, and are only down about 1% from that peak as of January:
That’s because there was a supply logjam for things like lumber during the big boom in housing sales in 2021. Starts couldn’t keep up with permits, and did not catch up until a few months ago.
Similarly, while *nominal* residential construction spending (blue in the graph below) has decreased substantially, once one adjusts for the cost of building materials (red) there really has not been a significant decline at all:
Eventually this anomaly will end. Single family units under construction have already turned down, while multi-family units appear to be peaking now:
3. Business are still short-handed compared with sales
Most readers are probably familiar with the Sahm rule, which holds that a 0.5% increase in the 3 month average of the unemployment rate has always meant that a recession is underway.
Well, initial jobless claims have a very long track record of being a leading indicator for the unemployment rate:
And needless to say, with initial jobless claims hovering near all-time lows, the unemployment rate is not going significantly higher in the immediate future:
Additionally, for many years I have pointed out that the YoY% change in real retail sales (/2) is a good leading indicator for the YoY% change in nonfarm payroll growth:
Another way of looking at that is that sales (blue below) tend to rise faster than employment (red) in the earlier part of an expansion, but rise slower than employment in the latter part. The trend line for this is intact going back 30 years:
While real, inflation-adjusted sales growth has stalled, employment hasn’t caught up with the trend yet - and if both current trends continue, it will take another year to do so.
Another way to look at this (albeit one in which I have lower confidence, because the data series is only 20 years old) is to compare job openings (blue) with hires (red) in the JOLTS report:
While openings have retreated substantially from their record highs, they remain much higher than they ever were before the pandemic, and well above the actual level of hires.
Conclusion
Put the above three factors together, and you have a pretty full explanation for why real sales, income, and employment have all continued to grow in the face of near-record Fed rate hikes.
So does that mean a recession is off? The long and short leading indicators continue to say No. Energy prices are no longer declining, so that tailwind is coming to an end. And the decline in housing permits and starts will sooner or later - probably sooner! - flow through into construction. As for the shortfall in employees vs. sales, that may be resolved by a decline in real sales and not just by further increases in employment.
But it does mean that we almost certainly won’t see an actual economic downturn until at least those first two tailwinds decisively turn negative.
For further details see:
3 Big Reasons A Recession Hasn't Started - Yet