'Not a lost cause': The argument for averting a recession in 2023

Economists put the odds of a recession this year at 70 percent. Consumers widely share that pessimism. And stock and bond investors have been rattled for months by fears of a looming slump.

What if they’re all wrong?

High inflation, which has prompted the Federal Reserve to jack up interest rates at the fastest pace in four decades, is showing signs of easing. Economic growth has clearly slowed but remained remarkably resilient. And job market gains are leveling off from their record-shattering levels of a year ago yet are still steady, as the latest employment report on Friday is likely to show.

All of that signals that a path may be emerging for a surprising — if still unlikely — scenario: that Fed Chair Jerome Powell will manage to cool inflation without triggering a recession, or at least to achieve the “very slight” downturn that President Joe Biden says is possible.

“This is not a lost cause,” David Mericle, chief U.S. economist at Goldman Sachs, said in an interview, adding that he thinks the Fed leadership takes the same view. “A recession is not inevitable. There’s a risk, a higher risk than usual, but we’re making pretty good progress so far.”

For Biden, escaping a recession would be a welcome reprieve after being battered by Republican accusations for more than a year that he stoked inflation with his big-spending policies. It could also provide a major boost to Democrats as the 2024 election campaigns get underway.

The optimists argue that economic growth has already decelerated enough to cool the job market, slowing wage growth and, ultimately, prices. That, they say, could prompt the Fed to pause its rate-hike campaign — something the central bank has hinted it’s likely to do in the first half of the year — without leading to mass layoffs. Indeed, data released on Thursday by payroll processor ADP showed that job growth remains strong but pay raises are starting to slow.

To most analysts, however, that’s still a long shot. In a recent Bloomberg survey, economists said there was a 7-in-10 chance of a recession this year — twice the number from six months earlier. The tech industry has been an early casualty of the Fed’s inflation fight, with giant corporations from Amazon to Facebook laying off thousands of employees, which could be a harbinger of what faces other industries in the months to come. And the central bank has often failed in the past to avert recessions after cranking up interest rates.

The looming threat of a downturn will continue to hang over the legislative agenda for the new Congress and could make or break Democrats’ chances of holding the White House in the next election.

That's because Powell isn’t just looking for price spikes to ease; he has vowed that the central bank won’t flinch from causing a recession if that’s what it takes to bring inflation back down toward the Fed’s goal of 2 percent, roughly a third of where it is now. And the moves the central bank has already made to increase borrowing costs — it hiked its benchmark interest rate last year from near zero to above 4 percent — could pack a much bigger punch this year as consumers whittle down their savings and companies put the brakes on hiring.

Still, Goldman Sachs isn’t alone in saying that the hit to the U.S. doesn’t have to be that severe. In a Wall Street Journal survey, JPMorgan Chase, Morgan Stanley, Credit Suisse and HSBC also said they expect the U.S. to avoid recession, even as most other banks disagreed.

And even if there is a downturn, many experts say it could look more just like flatlining rather than a noticeable drop in economic activity.

“Don’t put a capital ‘R’ on it,” said Mickey Levy, chief economist for Americas and Asia at Berenberg Capital Markets. “You and anybody else is barely going to know the difference between real GDP that declines by half a percent and one that increases by half a percent. It’s almost imperceptible.”

Lower gas prices have helped improve consumer sentiment, with Americans registering their highest level of optimism in seven months in December, according to a monthly survey from the Conference Board. Still, consumer expectations are in line with a recession.

Dana Peterson, chief economist at the Conference Board, warned that it might not be possible to beat inflation without having some kind of downturn, and she predicts a mild recession. After all, rising consumer spending and a low unemployment rate are part of what’s allowing prices to keep rising.

“If consumers continue to decide that they want to continue to spend, then the Fed’s going to have to do more and cause a recession that’s deeper and longer,” she said. “The Fed’s been saying, ‘Well, maybe you don’t need massive layoffs, you just need companies to pull their help wanted ads.’ But you do need consumers to pull back on their spending.”

Goldman’s Mericle is more optimistic. There’s a path for economic growth to slow to enough of a crawl to bring down inflation without actually leading to widespread pain in the job market, he said.

“The impact on the economy [from the Fed’s rate hikes] needs to keep us on this low growth path,” he said.

Stocks had a terrible year in 2022, but investors have strained against the Fed’s efforts to keep the market down as part of its fight against inflation. Central bank policymakers warned that “unwarranted” optimism from markets, in the form of higher prices and lower rates on bonds, could complicate their attempt to bring down inflation, according to minutes of their December meeting released on Wednesday.

But “if markets get much more pessimistic and financial conditions tighten, perhaps the Fed doesn’t need to do as much,” Mericle said.

Central bank policymakers don’t know whether inflation will continue to drop at a rapid clip without more damage to American employment and income. Powell himself has repeatedly said wage growth is accelerating faster than would be consistent with 2 percent inflation, as higher prices also drive employees to seek higher pay.

But the same dynamic can also work in reverse, Mericle said. That is, as inflation comes down, workers might feel less need to push for big raises.

“Wage growth and inflation both affect each other,” he said. “It is quite possible that as some of these deflationary impulses show up, whether it’s gas prices coming down or durable goods, that that makes an impact on inflation psychology, but this time for the better.”

Levy said the current economic situation is also unusual in ways that might bode well for a so-called soft landing, where the economy is cooled enough to bring down inflation but not so much that there is a sharp jump in joblessness.

“During a typical end of expansion, businesses have become overconfident, and they’ve hired too many people and they’ve built up their inventories way too high,” he said. So as growth slows, “they have to cut production and employment not just to meet slower demand but also to clean house.”

But this time around, supply shortages have hampered firms’ ability to meet demand on both fronts, which means they might decide to simply take a slight cut to their profit margins rather than laying off workers and slashing production, Levy added.

“Businesses still have shortages and so you don’t need to cut out those excesses,” he said.