So are we or aren't we already in recession? If you were looking for the advance estimate of second quarter Real GDP to settle the issue, you are going to be disappointed. Real GDP contracted another 0.9% annualized in the second quarter after plunging 1.6% in the first quarter. Many analysts have used the handy rule-of-thumb that two consecutive quarters of negative GDP growth constitutes a recession. If that is your metric, then you would be correct. But the problem is calling a recession is a lot more complicated than looking at one summary number even if that number is GDP. Indeed, the very definition of recession itself is actually quite vague.
The official arbiter on setting U.S. business cycle dates and thus deciding when a recession has begun is the National Bureau of Economic Research Business Cycle Dating Committee. The NBER defines a recession as "a significant decline in economic activity that is spread across the economy and lasts more than a few months". The committee takes into consideration three criteria – depth, diffusion, and duration. They look at a range of monthly measures of aggregate real economic activity such as real personal income less transfers, nonfarm payroll employment, real personal consumption expenditures, real manufacturing and trade sales, employment from the household survey, and industrial production. There is no fixed rule about what measures contribute information to the process or how they are weighed in their decisions.
The evidence from these monthly indicators that we have so far are mixed, but still decidedly weighted toward the expansion side of the argument. Nonfarm payroll growth averaged a solid 375,000 a month in the second quarter, though household employment contracted at a monthly average of 116,000 a month in the second quarter. Real consumer spending continued to advance at a 1.0% annualized pace in the second quarter. Industrial production increased 6.1% on an annualized basis in the second quarter. Real personal income less transfer payments eked out an increase of 0.24% in the second quarter. This hasn't stopped a raging debate to form on the recession question among macroeconomists, newspaper columnists and political pundits. This is a mid-term election year after all! Putting aside the are we or aren't we currently in recession debate for a moment, let's take a deeper dive into the second quarter GDP data and see what we can learn about what is actually going on with the U.S. economy right now.
The first point to make is that the quarterly GDP data over the last four quarters has been incredibly noisy from one quarter to the next. We have seen huge unusual swings in net exports and business inventories as port backlogs and order flows ebbed and flowed around COVID and Ukraine related supply-chain disruptions. At the very least these flows have muddied the waters of underlying domestic demand conditions and make it much more difficult to disentangle the signal from the noise from this data and could lead one to wrongly conclude the U.S. economy is already in recession. As the chart below illustrates, gross private investment contributed enormously to real GDP growth in the third and fourth quarter of 2021 as business inventory accumulation alone added 2.2% and 5.3% to GDP growth in those quarters. But by the first half of 2022, business inventory accumulation slowed subtracting 0.4 percentage points from U.S. GDP growth in the first quarter and a whopping 2.0 percentage points from GDP growth in the second.
Similarly, swelling import growth of over 18% annualized in the fourth and first quarters subtracted an additional 2.0 percentage points from GDP growth in the those quarters compared to the prior two quarters. By the second quarter excess retail inventories and slowing consumer demand led to a sharp improvement in the trade balance, adding 1.4 percentage points to GDP growth last quarter.
Supply Chain Disruptions Muddy The Waters on GDP
Given the remarkable volatility of business inventories and net exports due to the timing of supply chain disruptions and port backlogs, I think a more accurate measure of where the U.S. economy is right now in terms of demand and economic activity, can be drawn from a sub-component of the GDP report called Real Final Sales to Private Domestic Purchasers.
Real Final Sales To Private Domestic Purchasers Stalls
If you recall your Economics 101, GDP is just the addition of private consumption, business investment and inventory accumulation, government spending, and net exports. Real final sales of domestic purchasers takes business inventory changes, net exports and government spending, out of the equation. It is essentially the consumption plus business investment part of the GDP calculation - a pure view on final demand coming from consumers and businesses. What this measure reveals is a U.S. economy that is rapidly cooling down, and actually stopped growing in the second quarter, but has not yet fallen into contraction. In other words, we are in a sharp growth slowdown that may lead to outright recession down the road, but we probably aren't actually there yet.
So for those keeping score at home, at this point the two consecutive quarters of negative GDP growth are less of a recession signal than it is a sign that the U.S. economy has already entered a growth recession (a period of below potential growth) due to a combination of rapidly rising prices and interest rates.
To learn more, check out this week's U.S. Outlook Report.