Surveying the current economic landscape, it would take something resembling a miracle to pull the economy out of its current stagnation and avoid a recession.
he American economy is in a rough spot. For the last 18 months the economy has been mired in stagnation. Since the fourth quarter of 2022, it has only grown 1.2 percent in inflation-adjusted terms. For context, the average rate of growth over five quarters between 2010 and 2020 was around 2.7 percent—and economists have typically thought of the period after 2008 as being sluggish for growth. Turning to face future prospects, there seems every chance that things are set to get worse, not better.
Firstly there is the inflation, which seemed, as the weeks passed, to hang around like a stubborn and unpleasant smell. Headline inflation has fallen from its June 2022 high of 8.9 percent to just under 5 percent in April. But core inflation—that is, inflation with food and energy stripped out—has barely fallen at all and remains higher than headline inflation at 5.5 percent. This has led the Federal Reserve to recently signal that it may have to hike rates further.
The interest rate that the Fed targets—the Federal Funds Rate—currently stands at around 5 percent. This is the highest it has been since the summer of 2007, just before the last financial meltdown. The banking system is already creaking under the pressure of these interest rates. When the Fed hikes the interest rate, especially as quickly as it has in recent months, bond prices fall precipitously. In the past few months, this has led to multiple bank failures: Silicon Valley Bank, Signature, First Republic, all went down the drain.
Even without further rate hikes, other pressures are making themselves felt. The commercial real estate market has all but collapsed. A combination of rising interest rates and rising vacancies due to work-from-home have squeezed the sector and anxious banks are now engaged in a game of financial hot potato, passing commercial real estate loans around the table at discounted prices. At a certain point, liquidity in the commercial real estate market may dry up and these loans will, like mortgage-backed securities in 2008, turn into toxic waste and end up sealed away on the government’s balance sheet.
Nor are the problems in the commercial real estate market a mere fever dream of nervous bankers. A recent study by economists at NYU and Columbia examined the actual value of the commercial real estate in the wake of work-from-home in terms of its capacity to generate revenue through rents. They found that even with modest assumptions, it is likely that around half a trillion dollars will be wiped off the market.
While the commercial real estate market has recently caught the attention of the public, the residential market is not looking too hot either. According to the Case-Shiller U.S. National Home Price Index, prices have been falling since June 2022 and now stand about 2.3 percent below their peak. Housing markets are not like stock markets. They do not fall for a few months and then rally again. Typically, when we see prices decline for a year it portends further declines in the future.
The rumblings in real estate markets give us a hint of what is going to drive the recession: layoffs in the construction sector. Real estate has been, for the past 30 years, a key driver of recessions. The trouble starts in the financial sector, usually with Fed rate hikes. When the appetite for real estate lending starts to falter, the market reprices. When prices fall, construction slows and construction workers are laid off. As incomes fall and as orders for construction materials decline, the broader economy experiences knock-on effects, and we get a recession.
We are not there yet. Construction employment continues to grow, registering a healthy 2.5 percent annual rate of growth in May. But the construction industry can go from creating employment to shedding jobs remarkably quickly when the real estate sector starts to sour, as it is now. Consider recent history. In December 2006, construction employment was growing at 2 percent per year, like what we see today. By February 2007, however, it was contracting and by December 2007 the economy was in recession.
We can look for indications as to when the worm will turn in mortgage demand statistics. Mortgage applications have slowed from their peak growth of 8.5 percent in Q2 2022 to 6.1 percent in Q1 2023. This slowdown looks remarkably like what happened in 2006-07. Mortgage demand growth peaked in Q1 2006 and then started to fall. As we have already seen, just over a year later the construction industry started hemorrhaging jobs. If the same dynamics play out today, we should start to see construction layoffs this winter.
Good forecasters do not claim to have a crystal ball, however. It is less important to try to put an exact date on when the economy will start to crack up than it is to understand its weaknesses. Those weaknesses are now severe in the American economy. Surveying the current economic landscape, it would take something resembling a miracle to pull the economy out of its current stagnation and avoid a recession. The only real question now is: how deep will the recession be and will it be exacerbated by high inflation?
Philip Pilkington is a macroeconomist with nearly a decade of experience working in investment markets, he is the author of the book The Reformation in Economics: A Deconstruction and Reconstruction of Economic Theory.