A recession may not be on the immediate horizon, but the US economy is still on track to contract as consumers and businesses alike are squeezed by tight monetary policy.

The domestic economy grew by 2.1% in the second quarter. That was stronger than many other developed economies, but still below expectations of 2.4% growth. A solid labor market and sustained growth in consumer spending are, so far, bolstering economic growth.

But the impact of interest rates rising to above 5% from near zero in March 2022 has yet to fully feed through to businesses and households. Those effects will soon grow more apparent.

"Our view would fall in the delayed rather than canceled camp," Shannon Seery, an economist at Wells Fargo, said of prospects for a recession. "We continue to anticipate the US is gradually slowing and growth will outright contract early next year amid tighter financial conditions."

No recession yet

For now, the US economy continues to tick along nicely. Economists at S&P Global Market Intelligence revised up their forecast of real GDP growth for 2023 from 1.8% to 2.2% in August and said recession fears are ebbing.

The unemployment rate is still just 3.8% despite extensive tightening of monetary policy by the Federal Reserve and the restrictions that has placed on business investment and corporate profitability.

Inflation has also come down significantly, though that stalled in July when the personal consumption expenditures price index, excluding food and energy — the Fed's preferred inflation measure also known as core inflation — rose to 4.2% from 4.1% in June, approximately double the Fed's goal.

"The latest US economic data have boosted hopes that the Fed might actually succeed in pulling off a soft landing," said Rupert Thompson, chief economist at Kingswood Group.

The Fed also appears to be succeeding in slackening the labor market somewhat, a key ambition in limiting wage growth and preventing an inflationary wage-price spiral.

There is still further to go. There are only 6.36 million unemployed people chasing 8.83 million jobs, but this deficit in labor of 2.47 million is down markedly from a peak of 6.1 million in March 2022.

"Growth is off to a firm start in the third quarter, yet crucially the previously red-hot labor market continues to cool, " Thompson said. "Employment growth has slowed, the unemployment rate has edged higher, job vacancies are back down to more normal levels, and wage gains have moderated."

Cracks

Still, there are signs that the economy is set for a downward turn.

Those signs include Fed Chairman Jerome Powell's comments on the negative impact of higher interest rates on auto loans and the housing market at the recent Jackson Hole summit, as well as credit downgrades of regional lenders by S&P Global Ratings and Moody's, said Oliver Rust, head of product at independent inflation data aggregator Truflation.

"Cracks are beginning to appear in the US economy," Rust said. "Higher rates are also hurting the small and medium-sized enterprises that form the backbone of the US economy."

Growth in real disposable personal income slowed to an annualized 3.8% in July from 4.9% in June. The decline in savings levels that funded the boom in consumption as COVID-19 restrictions were lifted means that households will need to fund future spending through their income.

"We estimate 'excess' liquidity will run dry by the end of this year, and to the extent households continue to spend at robust rates after that will come with increased financial vulnerability and make an eventual economic recession worse off," Wells Fargo's Seery said.

Inflation will be key

The outlook for inflation will be crucial to determining monetary policy and therefore the likelihood of a recession.

"Weaker job figures and a deceleration in GDP growth pave the way for the Federal Reserve to hit the brakes on their ongoing spree of interest rate hikes," said Lewis Grant, senior portfolio manager for global equities at Federated Hermes Ltd.

However, central banks have to balance the risk of inflation becoming more entrenched if rates are reversed too soon.

"So while the data suggest that a soft landing is now looking possible, with inflation coming down and growth cooling, not collapsing, the risks of something harder are still there," said James Pomeroy, economist at HSBC.

With the inflation outlook and impact of monetary policy far from clear, a recession call is "particularly uncertain at the moment," according to Wells Fargo's Seery. The sooner it comes, however, the less severe it will be.

"If the labor market continues to slowly moderate over the course of this year and the US slips into recession early next, we're fairly confident the recession will be modest given household balance sheets should still be in fairly decent shape," Seery said.