A recession is now likely in 2023. Here's what could trigger a sharp downturn in the economy

When it’s still sunny and mild, it’s tough to imagine a winter storm brewing in the distance.

But it’s probably coming.

The economy is still on seemingly sturdy footing. Job growth remains solid. Consumer and business spending have held up despite historically high inflation and sharply rising interest rates.

And yet there are mounting warning signs. Employment gains are slowing. Savings cushions are wearing thin. Price increases remain high and corporate profits, which had stayed strong, appear to have softened, underscored by a bleak FedEx warning last week that contributed to a massive stock market sell-off.

Perhaps the darkest cloud over the economy, economists say, is that aggressive Federal Reserve interest rate hikes designed to tame inflation are likely to take a bigger toll on growth in the months ahead.

“The seeds of recession have been sown,” says economist Troy Ludtka of research firm Natixis.

In an interview, Oxford Economics' chief U.S. economist, Kathy Bostjancic, said the Fed is “on a mission…They’re raising interest rates (sharply) until inflation slows down” even if it triggers a downturn.

The odds of a slump are growing. Economists surveyed this month by Wolters Kluwer Blue Chip Economic Indicators say there’s a 54% chance of recession next year, according to their average estimate, up from 39% in a June survey.

A recession is a “significant decline in economic activity,” including jobs, retail sales, consumer spending and industrial production, according to the National Bureau of Economic Research, which declares the beginning and end of downturns.

Still, not all experts foresee a slump in in the next 18 months.

Mark Zandi, chief economist of Moody’s Analytics, believes the U.S. will dodge a slide unless the Fed hikes its key interest rate even more aggressively than planned if inflation doesn’t come down quickly enough or “there’s a shock.” Such a trauma could include the reemergence of a more virulent pandemic or an overseas crisis that drives up gasoline prices again, he says.

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Barring such events, Zandi believes low household debt and abundant savings should allow the nation to withstand the effects of high inflation and rising borrowing costs. In other words, economic activity should grow more slowly, cooling inflation but not decline.

Here’s how some top economists say a recession could play out within a few months:

Consumer spending keeps losing steam

Consumer spending was resilient earlier this year but the savings that fueled it are dwindling. A core measure of retail sales was flat in August and the economists surveyed by Wolters Kluwer expect consumption to rise just 1% next year.

While wages are increasing, yearly inflation, at 8.3% in August, is climbing faster. As a result, Americans are drawing from the $2.6 trillion in savings they built up from government aid and hunkering down during the health crisis. Zandi says the figure is now down to $2.5 trillion.

The checking account deposits of low-income households dipped below their pre-COVID-19 levels in the final months of 2021 and were about 25% below that threshold this spring, according to Moody’s and the Federal Deposit Insurance Corp.. Those households are important to the economy because they tend to spend, rather than save, most of their income.

Oxford’s Bostjancic still expects consumer spending to grow 2.5% this year but fall 0.5% in the first half of 2023. Earlier in 2022, most Americans spent more on discretionary purchases than they did a year prior but now a slight majority are spending less, according to August figures from Visa’s Spending Momentum Index.

While lower-income households are drawing down their savings amid soaring prices, higher-income people largely have exhausted their pent-up demand after returning to dining out, traveling and other activities, according to Visa.

Wealth effects turn negative

When stock and home prices increase significantly, Americans feel wealthier and spend more, and when values fall, they dial back. The S&P 500 index is down about 18% this year as the Fed has sharply raised rates..

Since it takes six to nine months for falling asset values to affect spending, Zandi says, stock investors could start moderating their purchases this fall. Every $1 drop in wealth decreases spending by 3 cents, Ludtka says. But he notes the impact could be larger now because households have a near-record 40% of their financial assets in stocks, up from about 30% in 2015.

Corporate profit growth slows

Companies have maintained fat profit margins even though they’ve had to pay more for materials and hike wages to deal with worker shortages. That’s because they’ve enjoyed “robust revenue growth and unusually high pricing power,” Bostjancic says in a research note.

Yet, she says, that’s about to change as consumers temper their spending. FactSet estimates earnings of S&P 500 companies grew 3.5% in the third quarter, which would be the slowest pace since 2020. As result, Bostjancic says, companies will reduce hiring and capital spending.

Job growth comes off a boom

Employers added a solid 315,000 jobs in August but that’s down from an average of 455,000 the first seven months of the year. Less job creation means less income and spending.

Also, average weekly overtime hours for factory workers has dropped 11% since February to the lowest level since 2020. That’s worrisome, Ludtka says, because the amount of overtime logged by existing workers can foreshadow future hiring.

Bostjancic expects hiring to slow and layoffs to spread, leading to about 500,000 net job losses in the spring of next year as the unemployment rate rises from the current 3.7% to 4.8%.

Consumer borrowing pulls back

Higher Fed interest rates already have hammered home sales and the construction of new housing, with the 30-year fixed mortgage rate nearly double the rate in early January.

Initially, as rates rise, lenders offset the impact by easing lending standards, Zandi says. But as the Fed lifts rates further, Zandi expects a bigger impact on consumer borrowing through credit cards, auto and personal loans. The average credit card rate is 21.6%, up from 19.55% early this year, according to LendingTree.

Business investment falls

Business investment was flat in the second quarter while a measure of capital spending rose at a healthy 7.7% annual rate from May through July, according to a Pantheon analysis of government figures.

But with borrowing costs rising due to higher Fed rates, big companies could be discouraged from borrowing to buy new equipment, build factories and other projects, Bostjancic says. She expects business investment to drop in the first half of 2023.

Yield curve stays inverted, an ominous signal

Normally, interest rates are higher for longer-term bonds than shorter-term ones because investors need to be rewarded for risking their money for a longer period.

Yet the yield on the 2-year Treasury bond edged above the 10-year Treasury for the second time this year in July and remains about four-tenths of a percentage point higher. Such an "inversion of the yield curve" has been a reliable signal of a coming recession because investors move money into safer longer-term assets – pushing their prices up and their yields down – when the economic outlook grows dimmer.

A yield curve inversion also can contribute to a recession by squeezing banks’ profit margins, leading to reduced lending. Banks generally make a profit by borrowing money at lower short-term rates, such as on customers’ savings deposits, and lending it out at higher yields and longer terms, such as for home and auto loans.

Europe goes into a recession

The euro area is now expected to enter a deep, prolonged recession later this year because of high inflation, soaring energy prices tied to Russia’s war with Ukraine, sharp central bank interest rate hikes and weak demand from other countries, Barclays says.

S&P 500 companies generate about 14% of their revenue from sales in Europe, according to FactSet. Bostjancic expects a downturn in the region to further dampen the confidence of U.S. corporate leaders, delivering another blow to their hiring and investment plans.

Industrial production slows

Industrial production fell 0.2% in August and Oxford expects it to “remain subdued” because of high inflation and interest rates, lower profits and investment, and the weakening global economy.

This article originally appeared on USA TODAY: Is a recession coming in 2023? Economists say it is likely.