Why the most widely anticipated recession in history never came

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Thu, Dec 28, 2023, 8:57 AM 7 min read

In the final Federal Reserve press conference of 2023, Fed chair Jerome Powell took a victory lap of sorts.

Economists — including those on the Fed's own staff — had widely expected a recession this year as the central bank raised interest rates to bring down persistently high inflation.

The economic downturn never came, though.

"A very high proportion of forecasters predicted very weak growth or a recession," Powell said. "Not only did that not happen, we actually had a very strong year."

While that's good news for businesses, consumers, and investors alike, the unexpected turn of events raises a question: How did forecasters get it so wildly wrong this time?

The answer lies in the unprecedented nature of the COVID pandemic and the historic $5 trillion fiscal stimulus the US government pumped into the economy in response, economists told Yahoo Finance in interviews.

"It's been a tremendous challenge," Deutsche Bank chief US economist Matthew Luzzetti said. "The nature of forecasting is that often you look back to history, either through your models, or through looking for historical parallels, and [try] to gauge how similar or different are things to the past and get historical average responses. ... And when you don't have an analogous period to look back to, it makes things incredibly difficult."

The consumer spending surprise

The 2023 economic story will be remembered as one of a resilient US consumer as people opened their wallets more than economists had projected. That occurred largely because Americans entered the year with more money than many realized, backed by trillions of dollars sent into the economy during the pandemic.

This led to a massive increase in excess savings to an extent that is not normally seen around recessions, according to Luzzetti. This additional money in consumers' wallets led to more spending than one would typically expect coming out of a recession, like the one that happened in the early stages of the pandemic in 2020.

Add to that the initial government estimate for savings was revised higher this year, and there's a clear picture that consumers were simply coming from a stronger position in 2023 than many economists had modeled.

"Up until a few months ago, we thought households were going to run out of this excess liquidity by the end of this year," Wells Fargo economist Shannon Seery said. "And then revisions of the data suggest that households have a bit more spending power in that capacity."

These changes "made forecasting very challenging," per Seery.

A chart from Deutsche Bank shows that projections for when households would run out of excess savings was pushed back significantly due to upward revisions in total savings held by Americans. — A chart from Deutsche Bank shows that projections for when households would run out of excess savings were pushed back significantly due to upward revisions in total savings held by Americans. (Deutsche Bank)

Households and businesses 'insulated' from rate increases

Economic teams at Wells Fargo, Deutsche Bank, Bank of America, EY, and Jefferies all recently told Yahoo Finance that they had expected higher interest rates to hit consumer wallets faster and more aggressively than they actually did.

Typically, a rising rate environment makes everything more expensive. It's more costly for Americans to take out loans. Mortgage rates shoot higher. The cost of capital for businesses increases too. This means employers have to cut expenses in other areas like staffing in order to offset higher costs for borrowing.

This time around, consumers and businesses had locked in low interest rates before or during the pandemic and therefore weren't exposed to the hefty increases that began in March 2022.

"You look at these very rapid rate increases, and you're assuming that means there's going to be these kind of catastrophic impacts on the economy," Jefferies US economist Thomas Simons said. "But in reality, both the household and the corporate sector are much more insulated from rate hikes than it appeared, and certainly than they have been in previous rate hiking cycles, based on just how they fund their activity."

To Simons, this played out clearly in the housing market. While mortgage rates hit their highest levels in more than 20 years with rates nearly touching 8%, few Americans ever actually paid that rate as the housing market effectively froze. Analysis from Bank of America showed the effective mortgage rate, which is what homeowners are actually paying, is closer to 4%.

A chart in Bank of America's 2024 economic outlook shows that while the mortgage rate has soared with rising interest rates the actual rate that many Americans are paying has only increased marginally over the past year. — A chart in Bank of America's 2024 economic outlook shows that while the mortgage rate has soared with rising interest rates, the actual rate many Americans are paying has only increased marginally over the past year. (Bank of America) · Bank of America Global Research

This kept consumers "insulated" from policy, per Bank of America chief US economist Michael Gapen. The Fed's aggressive moves at the start of the rate hiking cycle, combined with persistent recession calls from various players in the industry, prompted consumers and businesses to prepare for a surge in the cost of borrowing.

"It's a bit of a paradox: The more cautious people become, the less likely you are to get overextended and have a downturn," Gapen said.

And therefore "the so-called most widely forecasted recession in the history of mankind" could itself be part of the reason why recession never actually came, per Gapen, as many consumers were keenly aware that rates would be rising.

The labor market weakening that never arrived

The US economy lost more than 9 million jobs in 2020, the largest calendar-year decline on record, according to the Bureau of Labor Statistics. The biggest loss came in the leisure and hospitality industry as Americans largely stayed at home to avoid exposure to COVID and many businesses shuttered.

That made the job of forecasting even more challenging three years later. Many economists expected higher interest rates to restrain business activity and eventually lead to an uptick in the unemployment rate.

But some of the sectors hit the hardest during the pandemic, like leisure and hospitality, were still recovering in 2023 and contributed to the surprise gains in the labor market, per Luzzetti. In the private sector, Deutsche Bank's analysis showed 70% of the job gains this year have been in leisure and hospitality as well as healthcare and education. Strip those out, and the rate of job growth would be closer to a rate that typically precedes a recession, Luzzetti said.

The job additions, combined with a lack of job cuts, which many economists had initially projected, led to a strong labor market and historically low unemployment rate this year. EY economist Lydia Boussour believes the layoffs that many had expected likely never came because the challenges of hiring amid the economy's reopening — and the hefty investment spent to attract talent back into the workforce — was still top of mind for employers.

"Companies had a really hard time attracting the right talent and rebuilding their workforce in the aftermath of the pandemic," Boussour said. "And I think that was really a factor in seeing companies really holding on to their workforce and their best talent in this environment."

Additionally, strong wage growth and rising labor force participation led consumers to have more money to spend in 2023 than many anticipated.

"You're not going to get a recession in the US economy unless the consumer takes a step back, and the consumer probably won't take a step back unless labor markets are weakening," Gapen said.

A normal year on the horizon?

Economists are notably more split about what all this means for 2024. Some, like Gapen at BofA and the team at Goldman Sachs, don't see a recession in the year ahead. Others, like Deutsche Bank's Luzzetti, still see a mild recession coming in 2024 as the lagging impacts from the Fed's tightening campaign prompt companies to cut workers and send the unemployment rate higher.

Still, many are in agreement that the end of 2023 comes as the economy is significantly closer to its pre-pandemic normal. The difference between job openings and job hires is at its lowest level in more than two years. The labor force participation rate is back to pre-pandemic levels, and the significant wage bumps seen during the tight post-lockdown job market are evaporating.

All of this reflects a return to normal, a welcome sign for an industry that uses history to help it project what will come next.

"2024 looks like it's an economy which is on its way to normalizing," Luzzetti said. "And hopefully one where those typical relationships that we use as economists begin to exert themselves again, and it becomes a little bit easier to forecast."