The worst of inflation may be over, recession concerns remain

It was clear that a recession would likely hit in 2023.

Inflation remained high and the Federal Reserve had no option but to keep increasing interest rates. The S&P 500 was already in a bear market and companies, especially in the tech industry, were conducting significant layoffs to reduce expenses.

The Federal Reserve has hiked interest rates to the highest point in more than twenty years in an effort to curb inflation. Despite widespread expectations among economists that the central bank's forceful actions would push the economy into a recession, that scenario has not materialized.

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America may have done the impossible: Avoid a recession

On top of everything, the Philadelphia Phillies reaching the World Series was historically viewed as a bad sign for the economy, as a recession has often followed their victories. However, the economy benefited from the Phillies ultimately losing to the Houston Astros last year, as a recession was avoided.

The truth is that the failure to materialize in 2023 had little to do with baseball and more to do with sound policies and a bit of luck. However, it's important to remember the standard investment disclaimer: past performance is not a guarantee of future results.

The case for a recession in 2024

The possibility of a recession has increased since the Federal Reserve started raising interest rates in March 2022, according to Fed Chair Jerome Powell's remarks to reporters in December. Nevertheless, he stated that "there is scant evidence to suggest that the economy is currently in a recession."

Despite the economy appearing to be thriving, Powell cautioned that a recession could still occur within the next year. This is due to the potential for unexpected economic crises, such as a worldwide pandemic, to emerge at any time.

Despite any future unforeseen events, certain economists believe that current conditions still have the potential to bring about a recession in the upcoming year. "The recession is simply postponed, but not entirely eliminated," stated Kathy Bostjancic, chief economist at Nationwide Mutual.

Bostjancic closely monitors employment in the private services sector, excluding health and education, as it provides insight into the state of the economy. Sectors within private services such as transportation and leisure and hospitality are more susceptible to economic downturns, making them a key focus for her. According to Labor Department data, in November 2022 there were 92,000 new hires in the private services sector, but in November 2023, there was a significant decrease with only 22,000 new hires.

Overall, there has been a steady increase in job opportunities over the past year, resulting in the unemployment rate remaining below 4%.

However, Bostjancic is skeptical that this trend will continue into the new year. She anticipates a 65% likelihood of a minor economic downturn in 2024 and foresees the unemployment rate climbing to 5% by the third quarter. This is nearly one percentage point higher than the median projection of Fed officials for the unemployment rate in 2024, as stated in the latest Summary of Economic Projections.

Bostjancic's forecast of a decrease in income due to unemployment could lead to a decrease in consumer spending and potentially trigger a recession, she informed CNN. Unlike previous years, consumers are unable to draw from additional savings as they have already used up the funds they saved during the pandemic, she noted.

As 2024 approaches, the economy seems to be in good condition, with inflation nearing the Federal Reserve's target. However, this does not guarantee that a recession will not occur.

The Fed's current high interest rates are designed to slow the economy in order to bring inflation closer to its 2% target, but this could pose a recession risk. If inflation continues to decrease and the Fed delays in lowering interest rates, it could hinder economic growth, according to Louise Sheiner, a senior fellow at the Brookings Institution and the policy director for the Hutchins Center on Fiscal and Monetary Policy.

That means its going to be challenging for the Fed to determine when it makes sense to cut interest rates, if at all.

US Federal Reserve Board Chairman Jerome Powell speaks at a news conference at the headquarters of the Federal Reserve on December 13, in Washington, DC.

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The Federal Reserve believes it can reduce interest rates in 2024 due to the lag time it takes for interest rate changes to impact the economy. According to Sheiner, previous actions by the Fed may have already begun to slow the economy, potentially bringing inflation closer to the target, even if this is not currently reflected in the data. If the Fed decides not to adjust interest rates, there is a risk of inadvertently causing a recession by allowing inflation to exceed the target.

Conversely, there is also the risk that combating inflation will become significantly more challenging. According to Sheiner, if the Fed wants to convey its dedication to reducing inflation to 2%, it will need to "orchestrate a deceleration."

That could mean keeping rates higher for longer than investors are currently anticipating, or even raising interest rates.

The case for another year without a recession

The Fed could still potentially achieve a soft landing, where inflation decreases without a significant increase in unemployment. Despite only occurring a few times in the past 60 years, there is still a possibility for it to happen again, even though it is rare.

Goldman Sachs' chief US economist, David Mericle, is optimistic about a soft landing. In a November note, he expressed confidence that the most challenging phase of the inflation battle has passed and that the necessary conditions for inflation to stabilize are now established. He also believes that the most significant impacts of monetary and fiscal tightening are already behind us.

Although there were concerns about a recession last year, he stated that he does not currently see any significantly increased risks. With the unemployment rate at historically low levels and numerous job opportunities available, he believes it would be unexpected to see a sudden decline in the labor market.

His team has assessed the likelihood of a recession in the next 12 months to be just 15%, which he described as the "historical unconditional average." This means that in any given year, he believes there is at least a 15% chance of a recession. However, during the banking turmoil that began in March 2023, Goldman Sachs economists saw a 35% chance of a recession in the next 12 months when inflation was near its peak.

However, they revised their forecasts starting in June as inflation continued to improve, the labor market became more balanced, and banking stress eased.

While Mericle doesnt see any "obvious" trigger for a recession, he said it would likely be "some kind of unforeseen shock to the economy."