We are now 18 months into inflation that is above the 2.0 to 2.5% level that the Federal Reserve targets as a normal rate of inflation.
To slow that inflation rate, the Fed has raised its benchmark interest rate five times, from 3.25 to 6.25%. This has the effect of increasing the cost of borrowing, thus reducing consumer demand. It also increases the risk of a recession.
It is too early to predict a recession, and economists, including this columnist, have a poor track record of predicting recessions. However, it is not too soon to think through what we might expect with a recession and what unexpected risks might accompany a downturn.
The goal of the Fed’s higher interest rates is to cause consumers and businesses to purchase fewer goods and services. Naturally, the higher prices of inflation cause consumers and businesses to alter the mix of products they buy, but it doesn’t necessarily reduce demand. Higher interest rates do reduce demand, especially for big ticket items such as automobiles, RVs, homes and appliances.
There is still pent-up demand for new cars, and both RVs and homes are coming off of a blistering pace of sales. We already can see the effect of higher interest rates on all of these items. The price and quantity reductions aren’t yet at recession levels, but auto sales are down 25% from their 2021 highs, existing home sales are down 35%t from their January highs and RV sales are down 36% from this time last year.
None of these data are as bad as they appear. Some of the new car sales are stymied by continuing supply chain problems. Home and RV sales are down from what was an unsustainable pace over the past year. Viewed historically, the current slide in sales is unwelcome but not itself signs of a recession. Still, interest rates will continue to rise for several months, and all of these data will worsen.
Higher interest rates eventually begin to affect smaller purchases, as well. Consumers rush to pay off credit card debt, and the lower demand for big ticket items also spills over into other products. Lower demand for housing means fewer purchases of appliances and furniture, while demand for auto parts and construction materials will lessen.
This boosts the likelihood of a recession, which is likely different from our more recent experiences. We’ve been through a pandemic recession that affected mostly services. The Great Recession was led by a housing bubble, and that affected manufacturing. In 2001, we had a short, mild recession, as we did in 1990-1991. Both of those downturns saw slow labor market recoveries that could be attributed to other causes. The next year is likely to be far different.
The last recession we’ve had as a result of Fed tightening was in 1982. That will scare many old-timers, myself included, who recall the sharp decline in manufacturing. Whether or not this period of interest rate increases results in a recession, it is certain to hit manufacturing harder than did recent downturns.
In a typical post-World War II recession, about half of the GDP declines were in manufacturing. Within manufacturing, almost all of the declines were in consumer durable goods and in business equipment. These purchases are more sensitive to interest rates than services and so bear the brunt of the downturn. Indiana’s economy is modestly less manufacturing dependent than in 1982 but still the most manufacturing intensive in the nation. Indiana and the Midwest will bear a disproportionate shock if we go into recession.
Whether or not we go into recession, we should anticipate that manufacturing will struggle through much of 2023. The effects aren’t just limited to high interest rates. Our efforts to control inflation also mean the U.S. dollar is strengthening in value relative to other currencies worldwide. While that is superb if you are planning a trip to Paris or London, it also means U.S. exports are now more expensive than ever.
All this means is there is little chance manufacturing production does not decline in the coming months. Still, there is good news, as well. Adjusting for inflation, 2021 was the peak manufacturing production year in history. This is not an industry in decline, just one that needs fewer workers to set new production records. So a slowdown in manufacturing production comes right off of the peak of record production.
There are other good signs about the possible short-term effects of a recession. Since 2021, American manufacturing firms have struggled to find the workers they need. Many manufacturers, particularly in the Midwest, are facing their first tight labor markets in 25 years. This will make them more reluctant to reduce employment during a downturn.
This is precisely the type of occasion in which workshare legislation, which allows for partial layoffs, would ease the burden on employers and employees and lessen the shock of a recession. Not surprisingly, both unions and the state chamber of commerce pressed our legislature to do so. The legislature did not. On the bright side, this at least offers a natural experiment for economists.
The key challenge is understanding when inflation will end and how quickly interest rate changes affect the economy. This is a mathematical relationship that economists can measure with some ease. The problem is that the relationship is constant over time. New technology speeds the effect of interest increases, but it also speeds price changes for businesses. At the same time, buyers and sellers hedge risks with longer-term contracts, particularly for goods that require months to produce.
Some effects of interest rate increases will take as long as 18 months to work through the economy, others take a few minutes. So as of early October, perhaps two-thirds of the Fed’s interest rate increases have yet to affect consumer spending. This explains both that inflation remains a grueling presence and why the risk of recession grows each time the Fed raises rates in response.
Once inflation is seen to reverse course, the effect of interest rate hikes will continue for more than a year. So it is nearly impossible to perfectly time the level of interest rate increases needed to slow inflation without a recession.
This is why the so-called soft landing is so rare. We should no longer expect one, though we might be happily surprised. It is more likely now that we face a recession in the coming months. There are some good signs it won’t be deep and long, but those too can change. I don’t think an honest forecast can be made with more certainty than that.
Michael J. Hicks is the director of the Center for Business and Economic Research and the George and Frances Ball distinguished professor of economics in the Miller College of Business at Ball State University. His column appears in Indiana newspapers. Send comments to [email protected].