US Weekly Economic Commentary: Inching towards recession as markets play chicken with the Fed

Data on international trade and wholesale inventories for December proved close to our expectations in a light period for major releases last week.

Accordingly, we made little change to our estimate of first-quarter real GDP growth of -1.2%. Such a contraction is suggested by the weakening monthly profiles of final private domestic demand and industrial production late last year, and an unsustainably strong contribution to growth in the fourth quarter from inventory investment.

Our forecast for second-quarter growth, which we expect to be boosted by a strong seasonally adjusted rise in vehicle assemblies, is -0.2%. Our projections for growth are below consensus for the first quarter and are above consensus for the second.

We still expect the economy to slide into a shallow recession in the coming months, even after the report of unexpectedly strong employment growth for January. Demand is expected to continue to soften in lagged response to the tightening of financial conditions last year and as pandemic-era fiscal support—including temporary expansions of the child tax credit, SNAP benefits, and Medicaid eligibility—unwind early this year. Additional COVID-related healthcare benefits will end with the announced termination of the Public Health Emergency on May 11.

In newly reported data, and consistent with the late-2022 deceleration in real retail sales, growth of consumer credit slowed in December, and bank senior loan officers reported a further tightening in the terms of credit on all types of loans. Of particular interest, given its role our modeling, is banks' willingness to make consumer loans, which has fallen to a level seen only around recessions.

Reenforcing those signals, the inversion of the Treasury yield curve, which plays an important role in most recession probability models, has reached a degree not seen since the early 1980s. In another recent survey, over 90% of CEOs believed the economy is headed for recession this year—no surprise, given the string of announced layoffs in the finance and technology sectors. Eventually, the economy-wide payroll figures will reflect those job losses.

Fed vs. markets

The Fed intends to slow the economy to ease inflation pressures, but financial markets are making the FOMC's job more difficult by pricing in doubt that the Committee will push its policy rate as high, or for as long, as suggested by communications from the central bank.

Indeed, since September, when we first forecasted a recession, overall financial conditions have eased even as the Fed hiked the federal funds rate. Federal Reserve officials have begun pushing back on financial markets' expectations, with several speakers warning this week that the recent easing in financial conditions could lead the FOMC to raise its policy rate higher, for longer, than otherwise.

Investors, likely influenced by January's employment report and perhaps noting Friday's upward revision to recent seasonally adjusted readings on the Consumer Price Index, seem to have become more receptive to that message. Futures markets now see the Fed taking the federal funds rate above 5%, consistent with our current forecast, with an expected reversal in policy coming later than anticipated just a few weeks ago.

We expect some further tightening in financial conditions through the spring as the Fed delivers quarter-point rate hikes in March and May, as the Fed maintains its recent hawkish tone, and as markets abandon the game of chicken with the Fed.

'X day'

There's been no apparent progress made towards raising the debt ceiling, and this week Democrats abandoned notions of using a discharge petition to bring a clean debt ceiling bill directly to the House floor.

Meanwhile, hanging over markets and the economy is the approach to "X day" when, without new legislation, the Treasury will exhaust the "unconventional measures" being used to meet its financial obligations and fall into a technical, if not sovereign default.

Analysis of the Monthly Treasury Statement for January suggests spending is growing faster, and revenues slower, than previously anticipated, suggesting X day may arrive earlier than June, the Treasury's latest public estimate.

We'll be watching for timing updates from Treasury Secretary Yellen, but any such announcement is likely to unsettle financial markets. We do assume the debt ceiling is raised (or suspended) in time to avoid a default in June and that a budget for fiscal year 2024 is passed in time to avoid a government shutdown in October. However, the growing uncertainty as these dates approach will create additional headwinds for an economy already inching towards recession.

This week's economic releases:

• Consumer price index (Feb. 14): We expect both the overall CPI and the core CPI, which excludes the direct effect of movement in food and energy prices, rose 0.4% in January. That compares with an increase of 0.1% for overall CPI and a 0.4% gain in core CPI in December.
• Total retail and food services sales (Feb. 15): We estimate an increase of 1.4% in total retail and food services sales in January, and a 0.4% increase in sales outside of motor vehicles and parts dealers. Both would represent improvement over the prior two months, when sales declined.
• Total industrial production (Feb. 15): An increase would follow declines over the two prior months and would reinforce indications from the labor market in January (i.e., a robust gain in payrolls and low initial claims) that broad economic activity may have picked up in January.
• Producer price index for final demand (Feb. 16): We estimate a 0.3% increase in total PPI for final demand in January, compared with a 0.5% decline in December. We also estimate a 0.3% increase in core PPI for final demand, which excludes the direct effects of changes in prices for food and energy.
• New residential construction (Feb. 16): We estimate January housing starts of 1,258 thousand units. This would continue the slide in starts that's been underway for some time now.
• Conference Board's Leading Economic Index (Feb. 17): Another monthly decline in this indicator would suggest ongoing risk that the US economy is about to tip into recession.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.