EXPLAINER: Recession fears grow. But how high is the risk?

Inflation is at a 40-year high

Inflation is at a 40-year high. Stock prices are sinking. The Federal Reserve is making borrowing much costlier. And the economy actually shrank in the first three months of this year.

Is the United States at risk of enduring another recession, just two years after emerging from the last one?

For now, even the more pessimistic economists don't expect a downturn anytime soon. Despite the inflation squeeze, consumers — the primary driver of the economy — are still spending at a healthy pace. Businesses are investing in equipment and software, reflecting a positive outlook. And the job market is more robust than it's been in years, with hiring strong, layoffs way down and many employers desperate for more workers.

Yet several worrisome developments in recent weeks suggest that the risk of recession may be rising. High inflation has proved far more stubborn than many economists had expected. Russia's invasion of Ukraine has exacerbated global food and energy prices. Extreme lockdowns in China over COVID-19 are worsening supply shortages.

And when Federal Reserve Chair Jerome Powell spoke at a news conference last week, he reinforced the central bank's determination to do whatever it might take to curb inflation, including raising interest rates so high as to weaken the economy. If that happens, the Fed could potentially trigger a recession, perhaps in the second half of next year, economists say.

By mid-2023, the Fed's benchmark short-term rate, which affects many consumer and business loans, could reach levels not seen in 15 years. Analysts say the U.S. economy, which has thrived for years on the fuel of ultra-low borrowing costs, might not be able to withstand the impact of much higher rates.

"Recession risks are low now but elevated in 2023 as inflation could force the Fed to hike until it hurts,” Ethan Harris, global economist at Bank of America, said in a note to clients.

The nation's unemployment rate is at a near-half-century low of 3.6%, and employers are posting a record-high number of open jobs. So what might cause an economy with such a healthy labor market to suffer a recession?

Here's what the path to an eventual downturn could look like:

— The Fed's rate hikes are sure to slow spending in areas that require consumers to borrow, with housing the most visible example. The average rate on a 30-year fixed mortgage has already jumped to 5.25%, the highest level since 2009. A year ago, the average was below 3%. Home sales have fallen in response, and so have mortgage applications, a sign that sales will keep slowing. A similar trend could occur in other markets, for cars, appliances and furniture, for example.

— Borrowing costs for businesses are rising, as reflected in increased yields on corporate bonds. At some point, those higher rates could weaken business investment. If companies pull back on buying new equipment or expanding capacity, they will also start to slow hiring.

— Falling stock prices may discourage affluent households, who collectively hold the bulk of America's stock wealth, from spending as much on vacation travel, home renovations or new appliances. Broad stock indexes have tumbled for five straight weeks. Falling share prices also tend to diminish the ability of corporations to expand.

— Rising caution among companies and consumers about spending freely could further slow hiring or even lead to layoffs. If the economy were to lose jobs and the public were to grow more fearful, consumers would pull back further on spending.

— The consequences of high inflation would worsen this scenario. Wage growth, adjusted for inflation, would slow and leave Americans with even less purchasing power. Though a weaker economy would eventually reduce inflation, until then high prices could hinder consumer spending.

— Eventually, the slowdown would feed on itself, with layoffs mounting as economic growth slowed, leading consumers to increasingly cut back out of concern that they, too, might lose their jobs.

The clearest sign that a recession might be nearing, economists say, would be a steady rise in job losses and a surge in unemployment. As a rule of thumb, an increase in the unemployment rate of three-tenths of a percentage point, on average over the previous three months, has meant a recession will eventually follow.

Many economists also monitor changes in the interest payments, or yields, on different bonds for a recession signal known as an “inverted yield curve." This occurs when the yield on the 10-year Treasury falls below the yield on a short-term Treasury, such as the 3-month T-bill. That is unusual, because longer-term bonds typically pay investors a richer yield in exchange for tying up their money for a longer period.

Inverted yield curves generally mean investors expect a recession will occur and will compel the Fed to slash rates. Inverted curves often predate recessions. Still, it can take as long as 18 or 24 months for the downturn to arrive after the yield curve inverts.

A very brief inversion occurred last month, when the yield on the 2-year Treasury fell below the 10-year yield. Yet most economists downplayed it because it was short-lived. Many analysts also say that comparing the 3-month yield to the 10-year has a better track record. Those rates are not close to inverting now.

At his news conference last week, Powell said the Fed's goal was to raise rates to cool borrowing and spending so that companies would reduce their huge number of job openings. In turn, Powell hopes, companies won't have to raise pay as much, thereby easing inflation pressures, but without significant job losses or an outright recession.

“We have a good chance to have a soft, or soft-ish landing,” Powell said. “But I’ll say I do expect that this will be very challenging. It’s not going to be easy.”

Though economists say it's possible for the Fed to succeed, most also say they're skeptical that the central bank can tame such high inflation without eventually derailing the economy.

“That’s never been done before,” said Peter Hooper, Deutsche Bank's global head of economic research. “It would be remarkable if the Fed is able to achieve it.”

Deutsche Bank economists think the Fed will have to raise its key rate to at least 3.6% by mid-2023, enough to cause a recession by the end of that year. Still, Hooper suggested that the recession would prove relatively mild, with unemployment rising to only about 5%.

Karen Dynan, a Harvard economics professor and a former top economist at the Treasury Department, also said she thought a recession, if there is one, would likely be mild. American families are in much better financial shape than they were before the extended 2008-2009 Great Recession, when plunging home prices and lost jobs ruined many households' finances.

“Considerably more people have some financial cushion,” Dynan said. “Even if it does take a recession to bring down inflation, it probably won’t have to be a deep or long one.”