The preliminary GDP (Gross Domestic Product) results of the U.S. for the second quarter, released by the U.S. Bureau of Economic Analysis (BEA) on Thursday, July 28, came with a drop of 0.9% in annualized terms. In the first quarter, it also showed a decline, in the order of 1.6% in annual terms, after the overheated GDP growing 6.9% a year in the last quarter of 2021.
A reduction in private investment – particularly residential – and public spending in the federal, state, and municipal spheres dragged GDP down in the second quarter. It is important to note that private consumption increased at an annual rate of 1% in the quarter, discounting inflation (Figure 1).
Figure 1 – U.S. GDP components
Source: Richter, W. (2022). “GDP Sunk by Plunge in Private Investment, Drop in Government Spending. Consumer Spending Rose Despite Raging Inflation”, Wolf Street, July 28.
A commonly adopted convention is to call it a “technical recession” when there are at least two consecutive quarters of GDP decline. However, there are reasons to consider such a statement premature currently, even recognizing clear and undeniable signs of an economic growth slowdown at the margin.
First, these preliminary GDP figures are frequently revised. It should be noted the current discrepancy between GDP and GDI (Gross Domestic Income) figures. Theoretically the two numbers should be equivalent, as GDP measures the sum of final expenditures in an economy, while GDI adds all incomes (wages, profits, and interest payments). In practice, imperfections in statistical collections and differences in data sources allow differences between them, even if adjusted sometime later.
Well then! At this moment, the difference between them has no historical precedents and the GDI, in the first quarter, came with a positive number, while the GDP fell (Figure 2). According to a study by Jeremy Nalewaik, former economist at the Fed (Federal Reserve), estimates of GDI in general point to where GDP is revised.
Figure 2 – Measures of economic growth
Source: Irwin, N. and Brown, C. (2022). “1 big thing: The economy's diverging gauges”, Axios Macro, July 27.
In addition to the revision of GDP data, it must be considered that economists prefer to look at a set of indicators broader than the two quarterly GDPs of the “technical recession”. As suggested by the resilience of private consumption in the second quarter, the labor market remained tight. This tightening, by the way, was cited by Fed President Jeremy Powell, when denying that the economy is already in recession, during the interview, Wednesday July 27, after the Fed meeting that decided to raise its basic interest rate by 75 basis points to the range of 2.25-2.5%.
In June, 372,000 new jobs were added, and the unemployment rate stabilized at a historically low level of 3.6%. For every unemployed person, there were approximately two vacancies available, making this one of the tightest job markets in recent history (Figure 3). We must consider the fact that the labor force participation, although increased compared to the period of the pandemic, remains low.
Figure 3 – Current U.S. labor market is much tighter than in the past three recessions
Source: Lichfield, C. and Busch, S. (2022). “When does an economy enter recession?”, Atlantic Center, July 28.
Two other indicators released Friday, July 29, reinforce the point about the tight situation in the labor market, while also indicating reasons for the Fed to be concerned about the need to tighten its monetary policy further. The Employment Cost Index (ECI) report, which tracks wages and benefits paid by U.S. employers, showed that total pay for civilian workers during the second quarter increased by 1.3%, up by about 5.1% in twelve months. In addition, the “core” price index of basic personal consumption expenditures (PCE), which leaves out volatile items like food and energy and serves as the Fed's main benchmark, rose 0.6% in June, up 4.8% year-on-year.
Last week also had, of course, the Fed meeting and Powell's subsequent interview on Wednesday, after which equity markets went up despite the interest rate hike. The month of July ended up positive in these markets, after a first half of the year in which US stocks suffered a decline not seen in half a century (Figure 4). How to explain?
Source: Duguid, K. and Rovnik, N. (2022). “US stocks spring higher to close out best month since 2020”, Financial Times, July 29.
Markets have come to assign a high probability that the Fed will “pivot”, and reverse its tightening direction, given signs of an economic slowdown. “Bad news for the economy is good news for the markets”, became a motto.
On the one hand, Powell fueled this belief when he said in the interview that the basic interest rate was entering its “neutral” range, that is, the one that, in a broader time horizon, does not take away or add demand stimulus to economic activity. On the other hand, such a “neutral” rate assumes that inflation converges to the 2% that constitutes the Fed's average inflation target, in addition to clearly still needing something between 0.50% and 1% more to get there. Additionally, in the same interview, Powell said that the level of economic activity will have to go through a period below its potential for inflation to evolve to the target, which would require interest rates to remain above the “neutral” level for some time.
A chart presented by Robert Armstrong in his Financial Times article of July 28 illustrates the mismatch between Fed and market projections of the Federal funds rate (Figure 5). It compares what the Fed members projected last June for the Fed funds rate with market expectations as derived from the futures market. The market looks much more dovish than members of the Federal Open Market Committee.
Figure 5 – Fed funds rate projections
Source: Armstrong, R. (2022). “You see a dove, I see a hawk”, Financial Times, July 28.
The paradox is that, with the improvement in financial conditions expressed in stock prices, in addition to the signs of downward rigidity in core inflation shown last Friday, the Fed should be forced to tighten more, given that its priority is to lower the inflation even at the cost of a recession. It seems premature to bet on such a "pivot" by the Fed, and this recent refreshment of stock and bond markets tends to be reversed.
Strictly speaking, the tug-of-war between the Fed and the markets will remain fierce in the future ahead, with two points remaining unclear: if the economy does indeed fall into a recession, how shallow or deep will it be? How rigid downward will the inflation rate measured by its core turn out to be?
A lot will happen between now and the next Fed meeting in September, including news on inflation (and GDI, at the end of August). In my opinion, as of today, the question is whether the Fed will raise its rate by 0.50% or 0.75%. Stay tuned!
Otaviano Canuto, based in Washington, D.C, is a senior fellow at the Policy Center for the New South, a professorial lecturer of international affairs at the Elliott School of International Affairs - George Washington University, a nonresident senior fellow at Brookings Institution, a professor affiliate at UM6P, and principal at Center for Macroeconomics and Development. He is a former vice-president and a former executive director at the World Bank, a former executive director at the International Monetary Fund, and a former vice-president at the Inter-American Development Bank. He is also a former deputy minister for international affairs at Brazil’s Ministry of Finance and a former professor of economics at the University of São Paulo and the University of Campinas, Brazil.