Hot inflation and rapid Fed tightening move the economy closer to a recession

Current State

The hot core inflation print for August dimmed hopes for a rapid cooling of inflation while feeding concerns that further Fed tightening will lead to a recession. The labor market remains a source of economic strength with strong hiring demand and rising wages supporting household spending. But homes sales have dropped off sharply while poor sentiment readings from consumers and small businesses (albeit up this past month) suggest that overall activity is weakening in response to higher costs and interest rates. The stock market rally faltered over the past month as growth prospects slumped in the face of another steep rate hike from the Fed.

Future Outlook

While a recession next year remains far from certain, typical leading indicators are inching closer to recession signals. The 1- and 2-year Treasury note yields have been inverted with longer-term rates since July, historically the most reliable alarm bells for a downturn. Moreover, the 12-month change in the index of leading economic indicators turned negative in August as activity weakens broadly. This does not mean that the economy is imminently at risk of contracting. But it does suggest that the conditions for a recession are building and could culminate in a modest downturn in the second half of 2023 or early 2024.