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This is what has to happen for the US to avoid a deep recession

Phil Rosen   

This is what has to happen for the US to avoid a deep recession
  • Recession calls have swirled for over a year, but it's still possible the US doesn't end up in a steep downturn.
  • In an ideal scenario, the labor market would cool off faster and more sharply than expected, experts told Insider.

For over a year, economists have been warning that a recession is right around the corner. Inflation has cooled but remains high, the job market still looks tight, and the Federal Reserve is likely gearing up for more rate hikes.

But a full-blown downturn hasn't materialized. Last year, we saw two consecutive quarters of negative GDP — the technical definition of a recession — but the powers that be never made the official call.

Looking ahead, the odds don't look great. Yet there's still a plausible path forward for the US to avoid a worst-case scenario.

Labor market is key

Friday's labor market data appeared to give the Fed more reason to tighten the screws on the economy. The unemployment rate fell from 3.7% to 3.6% in June, and 209,000 jobs were added in the month.

For the US to secure the much vaunted soft-landing, that number needs to fall much further, according to Taylor Sohns, cofounder of LifeGoal Investments.

"The more people employed means the more people getting paid, and that means more people keeping inflation consistently high with spending," he told me on a phone call after Friday's economic data published. "The more the Fed takes rates higher, the less affordable an employee gets, so there have to be less jobs added on a monthly basis."

Andrew Patterson, a senior economist at Vanguard, told me similarly that the labor market poses the most important variable in the Fed's balancing act.

And while June's nonfarm payroll figures were below estimates, wage growth ticked higher than what was expected, giving the Fed the ammo it needs to keep policy tight.

To avoid a recession, Patterson explained, hiring and wage growth would both have to cool off much faster than anyone currently expects, which would then open the door to inflation cooling faster than expected.

"That way, the Fed won't have to exert as much pressure on the economy," Patterson said. He noted that Vanguard gives roughly a 10% chance of a no-recession scenario.

Less spending, but not at the expense of growth

Helping to stave off a downturn in the last year has been a highly resilient US consumer. But with pandemic savings running low and student loan payments set to restart, odds are that Americans will be tightening their belts soon, which in turn pushes the likelihood of a recession higher.

There is a chance, Sohns said, that spending eases enough for inflation to fall to the Fed's target range without economic growth taking a big hit.

"But Americans are spenders," he said. "When we get paid, we spend money."

Ultimately, he sees about a 25%-30% chance the central bank can reach its 2% target without a recession.

"If the Fed can pull this off, it will be incredibly impressive," Sohns said. "We've never brought inflation down from above 5% without a recession, so it would be a job well done by the Fed."

So what are markets doing through all of this? While most recession watchers have called for a steep sell-off in the stock market if recession strikes, a popular refrain comes to mind: The market is not the economy.

While a spending slowdown would be tough on consumer stocks, it wasn't long ago when the market sailed through what looked like it would be a crippling downturn. In a historic disconnect from economic conditions, stocks had a banner year in 2021, at the height of the coronavirus pandemic.

While there's no guarantee markets will fare as well in the next recession, some remain optimistic that a downturn is still far off, and that even if it does happen, it might not spell doom for investors.

"[T]he Fed will likely keep tightening, which will have a slowing effect," Brad McMillan, CIO of Commonwealth Financial Network, wrote in a note Friday. "Even with that headwind, the news remains good — and any recession is likely some time away, which should keep markets healthy,"

"In short," he continued, "while June was a good month, July may be more challenging. Even if it is, conditions remain favorable overall."

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