The American economy continues to defy conventional forecasters by humming along without much fanfare. Unlike them, I concluded already in early April that a “recession is less likely now” than it had been at the beginning of 2023.
Since then, the economy has continued to move along just as I predicted. It exhibits less weakness and more resiliency. That does not mean it will continue to grow as it did in 2021 and 2022, but instead of going into a recession, the worst we have to expect is a brief, mild slowdown.
There is one variable that can upset this and truly cause a recession. I will get back to it in a moment; first, let us look at the strong sides of the U.S. economy.
The labor market is doing well
We are now in the third year after the pandemic and its government-forced partial economic shutdown. While 2021 was a recovery year, 2022 and especially 2023 are normal years in terms of the economy. Therefore, if we want to know where we are in terms of macroeconomic performance, we can compare this year and the last to another two-year period that exhibited ‘normalcy’.
The most recent such period was 2018-2019. It was the height of the latest growth cycle, one that benefited in no small part from the Trump tax reform and the deregulations campaign he had launched. During those years, America saw the strongest economic growth in decades, one of the lowest unemployment rates in modern times, and sharply rising household earnings, especially in the lower income segments.
To get an idea of just how strong our current economy is, Figure 1 compares the employment rate for 2018-2019 (green line) to 2022 through the first half of 2023 (red). This rate illustrates the number of people aged 16 and over who have a job, as a share of the total population in that age segment. The numbers are not seasonally adjusted, which gives as accurate a picture as possible of what is ‘really’ happening on the labor market:
Figure 1
Source of raw data: Bureau of Labor Statistics
The closeness of today’s economy to the Trump economy is striking; the fact that we have not caught up in terms of the employment rate is not an indictment of the Biden administration. It simply shows how exceptional our economic performance was during Trump. What is clear from Figure 1, though, is that our economy is doing well and there is no sign of a recession here.
Figure 2 looks at the most popular labor-market metric: unemployment. The same comparison shows how eerily close we are today to where the Trump economy was. The fact that our unemployment is actually a bit lower can be attributed to the data reported in Figure 1: some of the people who would have been unemployed under the Trump economy have simply left the workforce.
Nevertheless, unemployment is low and is likely going to stay that way in the coming months. The key indicator of where the economy is going will be where unemployment is in September, when seasonal summer jobs are closed. If we end up above the Trump economy at that point, I will take that as one indicator of a pending recession:
Figure 2
Source of raw data: Bureau of Labor Statistics
FDI and GDP
While the labor market is doing well, things do not look quite as good as far as foreign direct investment, FDI, is concerned. This is an important variable: it shows how investors outside America evaluate our economy. We look specifically at new FDI to get as fresh an idea as possible of what foreign investors think about the U.S. economy.
The one problem with this data is that it does not update very quickly. The most recent numbers we have are from 2022. We can use them still, if we compare them to another key set of variables, namely the components of gross domestic product, GDP.
Last year, foreigners invested $177.5 billion in the United States (in so-called first-year investments), a comparatively low number. In the six years 2014-2019, the annual average was 77% higher at $314.4 billion.
It is to be expected that FDI fluctuates, but the 2022 number is the second lowest since 2014, beaten to the bottom only by 2020. But does it mean that foreigners had doubts about the U.S. economy already back then? To figure this out, we need to see where the money came from; if investors from around the globe reduced their investments here, we can take that as a sign of consensus that America in their minds showed signs of economic weakness.
Most of FDI into the United States comes from Europe. In the past nine years—the entire time period for which the BEA publishes this type of FDI data—Europeans have accounted for 59% of all new FDI in America. In 2022, their FDI investments here were 56% of what they were on average in 2014-2019.
Canadians cut their U.S. bound money flow by one third in 2022, again compared to the 2014-2019 average. Japanese investments, which have accounted for 7.6% of U.S. FDI, were down by almost 74%.
Altogether, Europe, Canada, and Japan are the sources of 85% of first-year foreign direct investments in the United States. Their consensus of reducing FDI in America indicates concerns about profitability. Since businesses profit when the economy is growing, concerns over a recession would motivate them to cut their exposure to the U.S. economy.
Even Chinese FDI in America declined in 2022: at a meager $427 million, they cut their investments by more than 95% compared to their pre-pandemic average. However, this does not have to be a sign that the Chinese expected a U.S. recession. Recently there has been increased scrutiny of Chinese investments in America.
Over the past nine years Chinese investors have on average accounted for only 2% of the total new FDI inflow to the U.S. economy.
Foreign direct investment is often about buying businesses in another country. Other FDI types involve the founding of a new business or the expansion of an existing one. Since the acquisition type dominates new, U.S.-bound FDI, any concerns for profitability can be (at least partly) verified or falsified by a look at gross fixed capital formation—business investments—in the U.S. economy.
Overall, business investments in the U.S. economy have cooled for two quarters in a row. In the last quarter of 2022, total capital formation in the U.S. economy amounted to $1,146.7 billion. This was a reduction from the third quarter; in Q1 of this year, it fell further to $1,122.1 billion. Adjusted for inflation, from mid-last year to the end of March this year, capital formation fell by more than 8%; from Q1 2022 the decline was 6.8%.
This would signal a weakening economy, were it not for the fact that businesses spent more money on building structures. This implies confidence in the future.
At the same time, residential investments plummeted by 18.6% in real terms. This is very likely due to rising interest rates, which have forced households to tighten their budgets for home purchases. This, in turn, would signal a recession, were it not for the fact that from Q1 of 2022 to Q1 this year total private consumption increased by 2.9% in real terms.
Since private consumption accounts for 70% of the U.S. economy, this explains a lot of the 2% real GDP growth we saw last year.
If the labor-market numbers through June were worse than they are now, we could expect that the negative sides of the GDP numbers would have spread throughout the economy. That does not appear to be the case: not only do Figures 1 and 2 illustrate a labor market in good shape, but other numbers from the Bureau of Labor Statistics speak a similar language:
- Average hourly earnings in the U.S. economy were 19.4% higher in June this year than in June 2019;
- The average work week is 1.4% shorter, but the weekly paycheck is still up 17.7%.
Despite the marginally shorter workweek, it is more common for U.S. workers to have a full-time job today as it was four years ago. Back then, 83.3% of all employees worked 35 hours or more; today that number is 84.1%. This tells us that workers work less overtime but put in more regular hours.
A labor market with a higher degree of full-time employees is generally more forward-looking than one where employers want to operate with a patchwork of part-time employees. The fact that the full-time share for June is the second highest for that month in at least ten years is a sign that employers are optimistic about the future.
The government is the problem
The one sector of the economy that brings some concern is the government. Its debt and the interest rates that are related to it are rising at problematic rates. Figure 3 reports the estimated annual cost of the debt as it has increased through this fiscal year, compared to the average interest rate on the debt:
Figure 3
Source of raw data: U.S. Treasury. Debt cost estimate courtesy of Futura Forecasting
In June, half of the rise in the debt cost (the light blue line) came from growing debt, and half of it from rising interest rates. The latter affects the cost of the debt through so-called rollover: maturing debt at a low interest rate is replaced by new debt, auctioned at a higher rate.
As an example, on June 26th the Treasury sold $42 billion worth of 2-year Treasury notes at a median yield of 4.625%. The total annual cost of this slice of the U.S. government debt will be $1.94 billion. This batch of debt partially replaced $69 billion worth of 2-year debt that was sold in June 2021 at an interest rate of 0.22%. The annual cost of this batch was $151 million.
This means that even though the new batch of 2-year debt was $27 billion smaller, its annual cost was $1.8 billion higher than the maturing batch.
Most new Treasury debt sells at substantially higher interest rates than maturing debt. In the past two weeks, every Treasury bill with a maturity of 6 months or less has auctioned at more than 5%. Securities with longer maturity sell at lower interest rates, but those rates are also rising.
The same trend is at work in the secondary market, where owners of U.S. debt can sell their Treasury securities for cash. As of July 10th, you could buy every Treasury with a maturity of one year or less and get an interest rate of more than 5%; the 4- and 6-month bills pay more than 5.5%. All maturities from 2 years and up pay more than 4%.
Three months ago, on April 10th, only two securities paid more than 5% in the secondary market: the 3- and 4-month bills. All maturities from 3 years and up offered an interest rate of less than 4% per year.
Inevitably, higher interest rates on U.S. debt raise rates generally. So far, this has only cooled off the real estate market; the automobile market appears to remain resilient. However, there will come a point when rising interest rates become too difficult for consumers to manage.
The big question is whether or not the U.S. economy will reach that point with or without the help of the Federal Reserve. As things look today, I do not see them raising rates in the near future. Therefore, the trend of rising interest rates is likely driven by growing investor concerns with the uninhibited growth of U.S. government debt.
It is possible that the concerns that drive investors to demand higher interest rates are fueled by rumors that Congress is seeking the path of least resistance for managing its budget deficits in coming years. Sources I trust explain that leading members of Congress do not seem willing to do much of any substance to change the current trajectory of the debt. They prefer to go back to deficit monetization.
In short: the Federal Reserve prints more money to buy more debt from the Treasury.
As of today, a scenario where the Federal Reserve returns to deficit monetization is only a rumor, and I do not see it happening this side of the 2024 election. However, given the far-reaching consequences for the U.S. economy from resumed monetization, it is worth taking seriously the hypothetical scenario where such policies make a return.
