U.S. Exit from Technical Recession Offers Only Short-lived Relief to Economy

"That should be enough to drive a bigger pullback in consumer spending, lowering inflation persistently but also pushing the economy into a mild recession early next year," - RBC Capital Markets. 

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The U.S. economy returned to growth with a third quarter performance that lifted it out of a technical recession but it still has to contend with a number of growing headwinds including the effect of Federal Reserve (Fed) interest rate policy, making a renewed slowdown highly likely for the months ahead.

U.S. economic growth was positive for the first time this year in the third quarter when GDP rose at a quarter-on-quarter pace of 2.6%, more than reversing a 0.6% fall from the prior quarter and effectively ending a technical recession that began with the new year.

Rising exports of goods and services combined with increased consumer spending to drive much of the third quarter rebound although nonresidential fixed investment and government spending at both the state and federal level also added to GDP during the period.

Gains from these categories were partially offset by declines in residential investment in things like home improvements and by a weaker pace of investment in inventories among private companies who had built up stockpiles of products and parts earlier in the year due to supply chain disruptions connected with the pandemic.

"Net trade added a bigger 2.8 percentage points to GDP growth, as ongoing moderation in supply chain bottlenecks supported a jump in exports all while lower demand for consumer goods suppressed imports," says Claire Fan, an economist at RBC Capital Markets.

Above: Sectoral contributions to U.S. GDP growth. Source: RBC Capital Markets.  

"But growth momentum is starting to wane for pockets of the economy. Housing markets were among the first to soften with the Federal Reserve hiking rates aggressively to cap inflation pressures. Retail sales have weakened as well with demand, especially for household goods softening. That's contributing to a large inventory build-up at general merchandise stores and lower inventory investment among retailers," Fan said on Thursday.

U.S. growth was strong last quarter but the economy is increasingly besieged by growing headwinds both at home and abroad with the energy crisis in Europe, economic turmoil in China and rising Federal Reserve interest rates featuring prominently among the factors likely to hold back growth.

The Fed has lifted its interest rates five times since March and recently warned using September's Federal Open Market Committee forecasts that the top end of the Fed Funds rate range is likely to reach 4.5% by year-end before rising further to 4.75% in the new year.

"Rising borrowing costs throughout the economy and the strong dollar are creating a massive headwind. At the same time, the weak external environment is adding to the downside risks to growth," says James Smith, a developed markets economist at ING.

"So while the US may have just exited a technical recession, the cold winds are set to get a whole lot chillier this winter and make recession feel much more real in early 2023," Smith and colleagues said following a review of Thursday's data.

Above: Interest rate implied by CME Group Fed Funds rate future for September 2023 month. 

The Federal Reserve's interest rate had been sitting close to zero at the start of the year but has risen rapidly since then in response to inflation rates that have neared double-digit percentages in recent months and which remained stubbornly elevated near their recent highs in September.

While rising commodity prices were important drivers of the earliest increases in inflation, other factors have also played an important role including the supply chain disruptions that have raised the cost of internationally traded goods as well as earlier stimulus packages of the Fed and federal government.

The U.S. core inflation rate rose from 6.3% to 6.6% in September after overlooking changes in volatile energy and food costs but the overall inflation rate remained stubbornly elevated at an annualised 8.2% when the latter items are included in the basket of goods for which price changes are measured. 

"Still-elevated price pressures mean the Fed is still a ways away from calling an end to its inflation battle. We expect another 150 bps of interest rate hikes from the Fed, with the terminal rate reaching 4.5% and 4.75% range by early 2023," RBC's Fan said in response to Thursday's GDP data.

"That should be enough to drive a bigger pullback in consumer spending, lowering inflation persistently but also pushing the economy into a mild recession early next year," she added.