submitted by
Uric Dufrene, Ph.D., Interim Executive Vice Chancellor for Academic Affairs, Sanders Chair in Business, Indiana University Southeast
The combination of 4-decade high inflation and the subsequent acceleration of interest rates almost assured a recession in 2023. Some economists had even forecast a 100% chance of a recession. Bloomberg Economics, for example, in October 2022 predicted that the probability of a recession was 100% within 12 months. One often-cited indicator was the difference in interest rates on 10-year and 2-year Treasury securities. The rate on 2-year Treasuries had moved higher than the rate on 10-year Treasuries, a consistent predictor of recessions in the past. In fact, for the past six recessions, a recession followed when the difference between the 10-year and 2-year moved negative.
We now know that the recession that was almost guaranteed never occurred. Growth was quite robust, with the 3rd quarter Gross Domestic Product (GDP), the market value of goods and services, hitting 4.9%, and the 4th quarter topping 3%. A closer look at GDP shows that the consumer was the primary driver of last year’s strong growth. Consumers were supposed to break over inflation and high-interest rates, but we saw the opposite. In three of the four quarters, consumers made the greatest contribution to the growth in GDP. Because the consumer makes up more than two-thirds of the U.S. economy, what happens to the consumer will have a lot to say about the overall state of the economy, including this coming year.
One of the drivers of consumer spending last year was the labor market. While job growth did decelerate from the previous year, the labor market remained quite strong. Average monthly job gains continued to exceed numbers observed prior to the pandemic, and the unemployment rate remained at historical lows. Job openings, one measure of the demand for workers, declined from the start of the year but remained higher than the number of unemployed. The growth in average hourly wages has declined from the recent peak of March 2022 but now exceeds the inflation rate. In fact, from April 2021 to April 2023, inflation exceeds the growth in average hourly wages, putting consumers in a foul mood. Consumer sentiment plummeted to the lowest level on record by June 2022, where similar levels had always been associated with a recession.
Since April 2023 however, the change in average hourly earnings surpassed the growth in prices, placing consumers in a stronger position. This is one of the reasons why consumer spending continued through 2023, thereby escaping a recession. Consumers have noticed, and both consumer sentiment and confidence have increased from the start of 2023. Continued low initial claims for unemployment, available job openings relative to the number of unemployed, strong wage gains relative to inflation, and monthly job creation, should continue to fuel a steady level of consumer spending. Households are also beginning to tap into home equity, reversing a decline in home equity loan activity since the Great Recession. This is fueled by the record high levels of household net worth, serving as a buffer to any downturn and support for consumer buying.
Risks to this consumer outlook are beginning to surface, however. The household debt service ratio saw a large decline coming out of the pandemic, as households were able to use government stimulus and pandemic-driven behavior to pay down debt. All those gains have been erased, and household debt is just under the level that existed prior to February 2020. Higher borrowing rates have impacted consumer payments, with delinquencies on credit cards and consumer loans now higher than the level that existed just prior to the pandemic.
We should expect interest rates to continue their decline through 2024. Declining mortgage and consumer borrowing rates will further boost consumer sentiment and confidence, helping sustain consumer spending. This depends on the continued decline in inflation through the year, and interest rate cuts anticipated by the Fed. 2024 is not off to a good start however, as inflation came in higher than expected, and there was an undershoot in retail sales, except for food and drinking places. One data point does not set a trend, and the next few months will provide key data for the remainder of the 2024 outlook.
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