A recession is looking unlikely — but it’s still wise to remain humble

A year ago, the overwhelming consensus of business leaders and economists was that the economy would soon suffer a recession.

What recession?

I wasn’t one of those economists, but to be fair, the overarching pessimism of the consensus was rooted in experience. In times past when the economy was plagued with high inflation and the Federal Reserve responded with aggressive interest rate hikes, a recession invariably followed. To expect the economy to navigate through without suffering a downturn was effectively saying that this time would be different.

Economists are loath to utter the words, “this time is different,” because most often it is not. But there are times when it is, and this appears to be one of them. Inflation is steadily moderating without a recession or even an economic slowdown. Notably, unemployment has remained steadfastly below an extraordinarily low 4% throughout.

Behind the economy’s surprisingly good performance is inflation’s more-or-less graceful retreat. What most pessimists got wrong was their view that inflation was largely fueled by overly strong demand, pumped up by the government support provided during the pandemic. If so, they reasoned, the only way to get inflation back down was for the Fed to jack up interest rates and hit demand hard, causing a recession.

But this was largely a misdiagnosis. The high inflation was instead largely the result of the supply shocks caused by the COVID-19 pandemic that scrambled supply chains and the job market, and by the Russian war in Ukraine and the resulting surge in oil, natural gas, agricultural, and other commodity prices. The inflation caused by these massive shocks conflated and pushed up inflation expectations — what we think inflation will be in the future — and wage growth. And that raised the specter of a dreaded wage-price spiral.

Fortunately, the inflationary fallout from these shocks is increasingly in the rearview mirror, inflation expectations have moderated, and the wage-price spiral never took root. The Fed’s rate hikes appear to be over; it is increasingly clear that a recession is not needed to get inflation back down to the central bank’s target in a timely way.

Consumers have been big beneficiaries of the lower inflation — while wage growth has slowed, wage gains have been outpacing inflation all year. Consumers’ real incomes or purchasing power is improving, supporting their stalwart spending. This, on top of their low and stable debt service burdens, greater stock and housing wealth (recent price corrections notwithstanding), and still-prodigious excess savings that built up during the pandemic.

Businesses also appear to be managing their payrolls differently this time. Employers are extraordinarily reluctant to lay off workers. In response to any softness in demand for their wares, they pull back on hiring, pare hours worked, and reduce the use of temporary help. Anything but resort to layoffs.

This probably stems from businesses’ difficulty finding and retaining workers since well before the pandemic and an understanding that this will remain a perennial problem given the aging out of the workforce by the large Baby Boomer cohort and the nation’s vexing immigration policies. Without lots of layoffs, it is hard to see why consumers would sharply curtail their spending — a necessary condition for recession.

My generally sanguine no-recession view of the economy notwithstanding, it is prudent not to be overly confident. I put the odds of a recession in the coming year at a still uncomfortably high 25%. In a typical year, recession odds would be near 15%, consistent with a recession once every six or seven years, as in recent decades.

Behind the still-elevated recession probabilities are the considerable number of downside risks. Most threatening is the prospect that the Fed will make a mistake. The Fed has a tough job — it must raise rates high enough and fast enough to sufficiently slow growth and quell inflation, but not too high and fast that it undermines the economy. So far so good, and I expect the Fed to succeed. But it has misjudged before.

The potential for oil prices to spike is a near constant threat to the economic outlook. Despite the Israel-Hamas war and the potential that the conflict will engulf the rest of the Middle East and oil supplies, the sanctions on Russian oil, and big production cuts by Saudi Arabia, oil prices have receded.

But it would not take much to cause prices to jump. Stronger Chinese oil demand or a crackdown on those evading the Russian oil sanctions could be the spark. Much higher prices for very long would undermine growth, fuel inflation, and potentially prompt more Fed rate hikes. This would be all but impossible for the economy to bear.

Economic forecasting is a fraught business. The economy is a complex, quickly changing set of relationships among not always rational households, businesses, and governments. It is continually buffeted by geopolitical, technological, and environmental shocks. In forecasting, it is wise to remain humble.

Having said that, even though the script is still being written and there are considerable risks, there is increasingly good reason to be confident that the pessimistic consensus that the economy will suffer a recession anytime soon will be proven wrong.

Mark Zandi is chief economist for Moody’s Analytics.