In addition to being a devastating health emergency, the COVID-19 pandemic sent shockwaves through the economy that are still being felt three years later.
Shutdowns of businesses and other operations – some mandated by governments in an attempt to prevent the spread of the virus – were severely detrimental to the economy. Governments around the world then provided massive amounts of stimulus to prevent an economic collapse but that led to significant levels of inflation globally. To fight inflation, central banks raised interest rates. In the United States, the Federal Reserve has increased interest rates 10 different times since March of 2022, finally deciding to hold steady in June of 2023.
Year-over-year inflation in the U.S. peaked at 9.1% in June of 2022 and has steadily declined since.
With inflation cutting into consumers’ purchasing power and higher interest rates increasing borrowing costs, many economic observers expected the U.S. economy to slow and dip into a recession this year. But after two quarters of GDP decline at the start of 2022, the U.S. economy continues to grow, albeit slowly. The Federal Reserve Bank of Atlanta projects second quarter growth of U.S. GDP at 2.3%. First quarter GDP growth was 2.0%.
The U.S. labor market, with an unemployment rate of only 3.6% in June, continues to bolster the economy through numerous headwinds. With year-over-year inflation down to 3.0% in June, a pause by The Fed on increasing interest rates, low unemployment and significant improvement in the stock market since September, some economic observers now say the U.S. economy might avoid a recession – and make a “soft landing.”
To check in on where things stand with the economy midway through 2023, BizTimes Milwaukee editor Andrew Weiland last month conducted a Q&A with a pair of economists: Michael Knetter, president and chief executive officer of the University of Wisconsin Foundation (and former White House economic advisor), and Brian Jacobsen, chief economist at Annex Wealth Management.
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BizTimes: Although there was negative growth for the first two quarters of 2022, the economy still has not officially entered a recession yet in this cycle. A recession has been widely expected, largely due to significant inflation and the Fed’s attempts to fight inflation by increasing interest rates. Is it possible that we are actually going to avoid a recession and make a soft landing?
Knetter: “It is very possible, thanks to the hot labor market and possible growth in labor supply that had been sidelined in the pandemic. Supply chains are working better as well.”
Jacobsen: “A key question is, ‘A soft landing for whom?’ Manufacturing and housing already had a recession. Services and the broad labor market are doing well, but credit availability is likely to contract. Consumers seem to be running out of stimulus funds and credit card capacity to keep services spending elevated. It really wasn’t until August 2022 that monetary policy started getting tight enough to actually start being considered restrictive. In the timescale of monetary policy, it’s still early days in feeling full the effects of tighter policy. Don’t declare victory yet.”
The U.S. unemployment rate in May was 3.7%, and in Wisconsin it was at 2.4%. That sure doesn’t sound like a recession to me. The labor market is the biggest thing pulling the economy along, isn’t it?
Knetter: “Absolutely. And it’s a combination of spending holding up, households facing inflation, and people being drawn back to the labor force by the higher wages and prices.”
Jacobsen: “The labor market is doing well, but a key question is, why? Hiring isn’t high just for the sake of hiring. During COVID, consumers shifted from spending on services to goods. They’re still shifting back to spending on services. The fastest growth over the past year has been spending on food services, accommodations, and recreation. People are craving experiences. The leisure and hospitality industry has seen payrolls expand by 5.7% over the past year while overall payrolls have expanded 2.67%.”
Can the labor market maintain its strong performance going forward?
Knetter: “As long as demand doesn’t collapse, yes. If the Fed can show enough patience in getting inflation down, they may not need to crush demand.”
Jacobsen: “Based on the trend in payrolls growth from 2015 through 2019, the (U.S.) economy is still short 4 million jobs. So, yes, the labor market can continue to improve even if the overall economy slows. The labor market is a lagging indicator where job growth is the last thing to slow. It’s also the last thing to accelerate coming out of a recession. With baby boomers retiring and how difficult it has been to find, attract and retain workers, the labor market damage from a recession could be unusually mild. That should help blunt the pain from any economic slowdown. The flipside is that business profits are likely to come under increasing pressure.”
The labor force participation rate has been improving in recent months. Do you think that’s a sign that more people who left the labor force during the pandemic are returning? Do you see that trend continuing? How much upside is there realistically to labor force participation?
Knetter: “Yes, it’s very much about labor supply, and inflation and higher wages are stimulating the return of supply. The place we might see more growth in participation is older retirees who might need more income now given higher prices they are facing.”
Jacobsen: “The labor force participation rate for the prime working age population has improved 1.5 percentage points for men and 2.9 percentage points for women. Those are big improvements and are close to where they were pre-COVID, finally. The labor force participation rate for those 55 and older has fallen and it doesn’t seem to be budging any higher. That may appear to be a structural change, but people did come out of retirement throughout the 2003 through 2007 economic expansion, so you never really know.”
Many were alarmed with the inflation rate in the U.S. during the past year, but now that’s slowing down. What do you expect inflation to look like in the coming months, and why?
Jacobsen: “A lot of people look at the year-over-year changes in prices as a measure of inflation, but the pros look at the shorter-term changes in the various components of inflation to see if there is a change in the trend. Inflation is really a mixed bag of goods and services and instead of everything going up or down in prices, we’re seeing a lot more price divergences. Inflation at the headline level will likely continue on a downward trend, but with plenty of potholes and bumps along the way. The cost of eating out versus at home was growing, but has begun to moderate a bit. Shelter costs include rent and hotels and both of those shot up last year, but are beginning to come back down to earth. Used car prices skyrocketed, but have begun to fall while new car prices are beginning to increase. Gasoline costs fell a lot from last year, but are beginning to stabilize if not trend higher. Airline fares were very elevated, but have begun to enter their descent. Medical costs have been on a downward trend but look like they could start to rebound.”
Encouraged by the slowing rate of inflation, the Fed has finally taken a pause on increasing interest rates. How significant is that? How long do you think the Fed will stand pat?
Knetter: “The Fed may do a couple more 25 basis point hikes yet this year. Again, it depends how patient they are in bringing inflation down.”
Jacobsen: “We don’t know because they don’t know. They’re flying by the seat of their pants. It is somewhat comforting that they decided to pause their rate hiking campaign in June, but what they say they plan on doing is only as credible as their forecasts. Their forecasts have been horribly wrong. They seem to come from a Magic 8 Ball instead of a crystal ball. One problem is that they tend to forget that monetary policy affects supply along with demand. They can crush the will of buyers of homes with higher mortgage rates, but that also reduces the inventory of existing homes available since people may feel locked into their low-rate mortgages. The Fed dug itself a hole by being too slow to hike, but now they’ve dug a different hole by hiking without a clear view of what those hikes mean for the economy. Prudence would suggest they should take the summer off.”
Perhaps the biggest economic red flag of the first half of 2023 has been turmoil in the banking sector. The failure of a few banks, including Silicon Valley Bank, had some worried that the industry was on the verge of a collapse like in 2008 that drove the economy into the Great Recession. That seems to have calmed and stabilized more recently. Are we out of the woods there? What’s your take on the state of the nation’s banking sector?
Knetter: “The big banks weathered stress tests very well. There could be more isolated issues from banks with unusual exposures to commercial real estate loans but I believe we are past the worst.”
Jacobsen: “I’m not worried about a cascade of bank failures. They really are in better financial shape than before the (2008) financial crisis. Most importantly, the Fed has their back. Banks have ample availability of funding and if they are in dire straits, the FDIC has a very comprehensive and rapid way to ring-fence the problem banks. With more than 4,000 commercial banks in the U.S., it would be surprising if some of them didn’t fail, but it will likely be due to problems specific to the individual banks. Bank exposure to commercial real estate is a real question. Smaller banks have more exposure than larger banks and commercial real estate, like all real estate, is very local. Lending standards are rising, bank profitability is falling, and it’s not exactly a recipe for good times for small businesses and households that rely on small banks for loans.”
With ongoing worries of a forthcoming recession and a banking sector facing stress, are banks significantly tightening their lending standards? Are we looking at the possibility of a credit crunch that slows economic activity?
Jacobsen: “I wouldn’t call it a crunch so much as a tightening. A crunch implies that it collapses quickly. We’re already seeing signs that standards are rising, availability is falling, but also demand for loans is falling. Businesses are cautious and that means they might not want to take out a loan at these higher rates. To the extent that they can finance themselves with their retained earnings, they seem to be opting that route.”
Consumers are still spending, but how long can they continue to do so? Inflation is causing many consumers to eat into savings and to borrow more. Are we in danger of a consumer spending slowdown that tips the economy into recession?
Knetter: “So far, we are muddling through. This is the million-dollar question and it’s probably 50-50 whether spending, labor supply, wage and price inflation can keep in a balance that allows slow growth to continue.”
Jacobsen: “It depends on what type of spending. In recessions, it is spending on durable goods like cars and appliances that are the first to fall. Service spending usually just slows instead of becoming outright negative. This could be a little weird as spending on durable goods has already gone negative a few times over the past year. It’s services spending that has been the engine pulling the rest of the consumption train along. But service spending – especially on non-essential services like recreation, leisure and dining out – seems most vulnerable to a pullback.”
Has there been enough wage growth to offset inflation?
Knetter: “On average, it’s kept real wages steady but, by definition, that also adds a new underlying driver to inflation across the economy: wage growth that firms try to pass to higher prices.”
Jacobsen: “Since the middle of 2020, inflation-adjusted weekly earnings has been falling. The nominal increase in wages has been positive, but inflation has eaten away at those gains. In June 2022, real weekly earnings began to stabilize. Lower income and younger workers have seen their real earnings improve, but the broader population hasn’t really seen many gains.”
The stock market has performed better lately, leading some to declare it a bull market, while others are skeptical. What do you think?
Knetter: “Seven tech stocks have dominated the rise of the S&P 500: Amazon, Apple, Microsoft, Alphabet, Meta, NVIDIA and Tesla. The other 493 have wandered pretty aimlessly. So that might be a ‘bull’ bull market. Tech was beaten up so badly, some of those seven became ‘value’ stocks for brief periods. Keep in mind inflation has been running above target for many months, which erodes the real return investors are getting here. Nominal growth fueled in part by inflation makes the market look better than it is in delivering future purchasing power.”
Jacobsen: “We think it’s likely a lazy bull market and not a raging bull. They differ in that some market recoveries are very rapid. Those are raging bulls. We have lingering problems and a lazy bull market is one where you can go from bear market lows to a longer-term increase but characterized by many setbacks and pauses along the way.”
What about commercial real estate, and the office market in particular? The post-COVID work-from-home and hybrid work environment has caused a huge decline in demand for office space. What’s going to happen when a massive number of office tenants get to the end of their leases and then decide not to renew because they don’t need the space anymore, or perhaps they only require a smaller space? Are we on the verge of a huge downturn for the office real estate market, and what could that mean for banks and other lenders that have financed office buildings, which could be headed for foreclosure?
Knetter: “I am confident that the demand for commercial office space is on a lower trajectory since pandemic-induced work-from-home experiments gave everyone new perspectives on the viability of alternate work modalities. Industrial and distribution commercial space may be growing above prior expectations. I would not blow this out of proportion. The value of commercial office space was estimated around $2.5 trillion as of 2018 (pre-pandemic). That is less than Apple's valuation today. I realize that leverage can magnify the impact of valuation changes to office space but I believe it is a manageable situation.”
Jacobsen: “We’ve already seen that. Many commercial leases can extend for long periods, but some are shorter than others. There’s also a lot of overlap in lease terms where some leases are expiring in any given year. Vacancy rates for offices are already high. The key question is whether the property owner is over-levered and whether their cash flow profile can support some vacancy.”
We are seeing a lot of construction activity in the Milwaukee area, but is that sustainable as interest rates and costs of building materials have risen? Construction projects are clearly harder to finance now. Do you expect a construction slowdown?
Knetter: “Nationwide, it should slow down due to higher rates. Locally, Milwaukee and the Fox Valley may benefit from restoring of some manufacturing and other economic development initiatives.”
Jacobsen: “Construction activity slows or grinds to a halt during recessions. There’s still a high demand for mixed-use and residential properties. Retail and office space is the area that is struggling the most. It really does depend on the use of the property and the financing as to whether it will be viable. Some projects may have low-cost financing locked in or they may have a good chunk financed with equity. There are a lot of institutional investors that are eyeing up opportunities to buy distressed situations.”
In the housing market there has been a lot of multi-family development in the Milwaukee area, but local realtors say there have not been enough new homes built to meet demand. As a result, single-family home sales are in decline, housing costs are rising and lack of affordable housing is a major problem. How big of a problem is this and do you see signs of solutions coming anytime soon?
Knetter: “House prices are likely inflated by limited supply being offered in the secondary market. This could be due to the lock-in potential sellers may feel with mortgages below 3%, which is the case for many homeowners today. The value of holding such a mortgage went way up when interest rates rose. Changing homes got much more expensive. That will dissipate with time. Affordable housing is one dimension of a bigger national problem: too many adults with too little human capital, technical or general work skills. That limits their ability to function in the labor market, leaving them with too little earning capacity to meet their needs for a range of necessities, including housing, food, transportation, etc. There may be special features (NIMBY-ism, or Not in My Backyard) that impact our appetite for building affordable housing.”
Jacobsen: “It's a nationwide problem. The existing home market is a mess as 90% of homeowners have mortgage rates that are lower than 6%. If we get some stability with monetary policy and mortgage rates, then time will heal the scarring in the housing market. People will still want to downsize or upsize or move due to jobs or retirement.”
So, what’s your call: when will the U.S. economy go into recession?
Knetter: “I believe we are muddling through a slow growth period and will flirt with recession while avoiding a technical recession. One reason is the tight labor market. But growth in real GDP and productivity will be relatively weak until a possible burst fueled by the application of AI in 2025 or later.”
Jacobsen: “Parts of the economy have already been in a recession. Rather than being one where every sector falls together, this has been a roving recession. It will likely lead to a stumbling and staggered recovery.”
