The U.S. enjoyed its party last year, but now it's feeling the pain.

After GDP expanded at an average rate of 5.7% in the past year--its highest in 37 years--economic activity has slowed considerably. A disturbing 1.6% drop in first-quarter GDP stemmed from weakness in trade and inventories, though domestic activity was healthy. However, high prices and interest rates have hurt affordability and since slowed domestic activity through June. The health of the U.S. economy now faces challenges from extremely high inflation and supply-chain disruptions, exacerbated by the Russia-Ukraine conflict and a new round of lockdowns in China.

On top of that, the Federal Reserve's interest rate policy rocket is heading for the moon. The Fed already raised rates by 75 basis points (bps) in June--the first time the Fed has raised rates this high since 1994--with rates likely to reach 3.50%-3.75% by mid-2023. In our Business Cycle Barometer publication, we look for early signals of deceleration and recession. We've found them.

Our dashboard of leading indicators through June signals that U.S. economic momentum has continued to worsen. As such, whether the U.S economy can avoid a recession feels like a toss-up. Our base case already assumes a low-growth recession next year, with GDP at just 1.6% and the unemployment rate climbing. Our qualitative assessment of recession risk over the next 12 months is 45%, within a wider range of 40%-50%. We see risks closer to the top of that range heading into 2023 as cumulative rate hikes take hold (see appendix for the National Bureau of Economic Research definition of recession).

Worsening Near-Term Growth Prospects

Our dashboard of leading indicators through June signals that U.S. economic momentum has slowed significantly. In June, seven of the nine leading indicators we track sent negative (five) or neutral (two) signals on near-term economic growth prospects (we tracked 10 leading indicators in April, with two negative and five neutral; June data on the Freight Transportation Services Index, the 10th leading indicator we track, is pending at the time of this report).

Now, even our term spread indicator has turned neutral (through July 22) after holding in positive territory since January 2022. This is a significant worsening from the heyday of November 2021, when seven out of 10 indicators were positive and the remaining three were neutral. (For details on what these signals mean, see the appendix.)

As persistent price pressures and higher borrowing costs weigh on affordability and as the Fed aggressively tightens rates, we cannot rule out a recession in the next 12 months.

The high prices and rising interest rates hurt affordability and slowed domestic activity in the second quarter. We expect housing in particular to weigh on second-quarter economic growth. Building permits, a leading indicator in our dashboard, fell to 1.7 million in June from 1.9 million in March, while existing home sales fell by 5.4% month over month in June to a disappointing 5.12 million sales.

In line with this sobering assessment, as of July 19, the Federal Reserve of Atlanta's GDPNow estimates for real GDP in second-quarter 2022 pointed to a 1.6% contraction of the economy, before the housing data was released on July 20. According to GDPNow, real final sales--a reliable indicator of economic activity--decelerated to just 0.9% in the second quarter from 2.9% in the first quarter. S&P Global Market Intelligence's U.S. GDP tracking report on July 27 estimated a 1.3% contraction in second-quarter 2022. Real final sales are estimated to decelerate to a 0.6% increase in the same quarter.

Time To Worry? A Comparison With Past Business Cycles

In our analysis, seven out of nine leading indicators in non-positive territory signals a weakening of economic conditions and may signal a recession (see chart 1). Indeed, within one year before the last three recessions--in 2001, 2007, and 2020--the proportion of non-positive signals in our dashboard surpassed 60%. Having five negative signals is an especially strong marker of an impending slowdown in the economy.

Chart 1

Yields and quantitative risk of recession

Monthly yield spreads (we use the term spread--the difference between 10-year and three-month Treasury yields--in our dashboard) were in positive territory through June but have weakened considerably in July. The term spread for the 10-year/three-month declined to 0.77% in July (through July 22) from 1.65% in June. The near-term forward spread, closely monitored by the Fed, also worsened in July, to 0.99% through July 15 from 1.93% in June (2.23% in May).

July averages through July 22 for the 10-year/two-year and the 10-year/one-year are now in negative territory, at -0.12% and -0.08%, respectively, falling from +0.14% and +0.49 in June. While this is a concern, we look for two consecutive months in negative territory before we call the inversion a recession signal (see "Despite Rising Risks, Yield Curve Is Not Yet Signaling Recession," May 4, 2022). For perspective, from December 2021 to July 15, 2022, the near-term forward spread declined 9.9 bps, while the 10-year/three-month spread, 10-year/one-year spread, and 10-year/two-year spread (monthly averages) declined by 64 bps, 125 bps, and 91 bps, respectively, through July 20. As July comes to a close, the 10-year/three-month spread's month-to-date average has fallen into neutral territory after remaining in positive territory for six straight months.

Our quantitative assessment of recession risk, based on a spread risks model, increased significantly in July across all spreads we track. The odds of recession in the next 12 months ranged from 14% for the near-term forward spread to 19% for the 10-year/three-month, 27% for the 10-year/one-year, and 28% for the 10-year/two-year (through July 22). The odds of recession in June had ranged from 8.2% (10-year/three-month spread) to 20.5% (10-year/two-year spread).

Chart 2

Credit spread, S&P 500, and consumer sentiment

The financial market has continued to price in a worsening economic outlook in the past two months. The widening credit spread has been flashing neutral signals since March (see chart 4). Moreover, the ongoing correction of the S&P 500, now in bear market territory, has pushed the index to its worst start to a year dating back to at least 1970--clearly flashing negative on our dashboard (see chart 5).

The Consumer Sentiment Index for June plunged to an all-time low of 50. It ticked up to just 51.1 in its preliminary July reading, indicating it will remain in negative territory this month as well (see chart 6). This negative signal is a reminder of how lingering pessimism among households is already affecting real consumer expenditure. With June headline inflation at 9.1%, households' purchasing power has eroded rapidly--a situation that threatens the current economic expansion.

Many households had a buffer from cumulative savings during the pandemic that enabled them to continue to buy items earlier in the year, despite dwindling purchasing power. But that buffer seems to be wearing thin, with people at the low end of the income spectrum squeezed as extremely high prices for food and fuel cut into discretionary spending. And higher-income households, stung by losses in the stock market, have also likely felt the pinch and should slow spending activity later this year.

Building permits and New Orders Index

Building permits weakened dramatically in May and June and are now solidly in negative territory according to our analysis. The ISM PMI New Orders Index for June also fell into negative territory, and the subindex dropped to 49.2--contraction territory--for the first time since May 2020, when the index was on the rebound after bottoming out the previous month.

This comes after both indicators sent several neutral signals since January, indicating slower growth of real production activities (see charts 7 and 8). Continued supply-chain constraints and waning demand for new homes, as a sharp increase in interest rates and high prices dampen housing affordability, are major reasons behind the weakness in goods-sector activities.

Credit availability indicators

Worsening growth prospects are also visible in the availability of credit and tightening financial conditions. More banks kept their lending standards tight in the second quarter, and the growth signal from the opinion of senior loan officers remained neutral through the quarter after starting the year in positive territory (see chart 9).

The National Financial Conditions Index (NFCI) reading was -0.17 in June, up from -0.24 a month prior. On the other hand, the adjusted NFCI turned positive. Both indices point to average tightening financial conditions in the country. To put things in perspective, the NFCI is at a two-year high while the adjusted NFCI is at a 25-month high. Access to financing has continued to wane over the past three months (see chart 10), portending deteriorating financial conditions for households and businesses in the second quarter. Historically, the NFCI and Financial Fragility Indicator (FFI) have moved in tandem, leading us to believe that the FFI will continue its upward trajectory for the second quarter (see "Financial Fragility Of U.S. Households And Businesses: On The Rise While Still Below Its Historical Average," July 11, 2022).

Real-time economic conditions

Fortunately, at least one real-time economic indicator is still supportive of economic growth. Jobless claims adjusted for the labor force, which respond rapidly to changing business conditions, are still in positive territory as the jobs market remains tight, at least for now (see chart 11). The annual growth rate of the Freight Transportation Services Index, which is released with a lag, is also in positive territory through May (see chart 12).

Leading Indicators

Chart 3

Chart 4

Chart 5

Chart 6

Chart 7

Chart 8

Chart 9

Chart 10

Chart 11

Chart 12

Appendix

Financial Fragility Indicator

We've added a new indicator, the Financial Fragility Indicator (FFI), to our analysis. It describes the health of balance sheets of households and businesses. The higher the index is, the worse the financial conditions of households and businesses. The indicator adds value to the dashboard because it describes the financial conditions of the real sector, unlike the Fed's loan survey and the National Financial Conditions Index (NFCI), which describe the easiness to access funds from banks and in the capital market. That said, NFCI and the Fed's loan survey are timelier than FFI, especially NFCI, which is published each week. The three indicators often move with each other, since financial conditions of borrowers are important determinants of the easiness to access funds via the financial system. (For more about FFI, see "Economic Research: The Financial Fragility Of U.S. Households And Businesses Hit A Decade Low In The First Quarter," July 30, 2021.)

Automated signal generation process

To improve the consistency and transparency of our dashboard, since September 2021, we have used an automatic quantitative decision rule to generate growth signals. The updated decision rule is based on judgments of our economists in the past when constructing the signals. Recreating the dashboard using historical data can replicate previous manually generated signals by 81%.

Going forward, the automatically generated dashboard will be the baseline of our publication, though judgment is necessary--for example, when an indicator appears very close to the line separating the neutral and negative/positive territories. We would discuss our manual adjustments in the footnote of the dashboard.

Definitions of positive/neutral/negative signals

• Positive: Overall economic activity will continue to expand in the near term, without an obvious slowdown.
• Neutral: Overall economic activity will continue to expand but may be slower. Right after a recession, a neutral signal indicates that the recovery may have just started.
• Negative: Overall economic activities will start to contract shortly afterward, roughly within a year.

National Bureau of Economic Research definition of recession

When determining recession, the National Bureau of Economic Research (NBER) Business Cycle Dating Committee considers several monthly indicators--including employment, personal income, and industrial production--as well as quarterly GDP growth. The NBER's definition emphasizes that a recession involves a significant decline in economic activity that is spread across the economy and lasts more than a few months. It notes that in its interpretation of this definition, it treats the three criteria--depth, diffusion, and duration--as somewhat interchangeable. That is, while each criterion needs to be met individually to some degree, extreme conditions revealed by one criterion may partially offset weaker indications from another. For more on this, please see https://www.nber.org/research/business-cycle-dating.