Inflation rose to a 40-year high in the first half of 2022, so the U.S. Federal Reserve began aggressively raising interest rates and tightening the money supply to combat it. This has happened before — many times in the past 100 years — and every time a recession followed. With such economic clouds darkening the horizon, analysts are starting to predict that the U.S. could enter a new recession in 2022 or 2023.
How likely is a recession this time? And what can business leaders do to protect their companies from an oncoming economic storm?
Is a Recession Coming?
No matter how convincingly a person or institution argues for or against a coming recession, they just don’t know. Not until after it starts, and the National Bureau of Economic Research (NBER) — the accepted arbiter of U.S. recessions — pinpoints the month, can businesspeople know for sure that a recession is happening.
But that said, surveys of economists show consistently rising expectations for a recession by mid-to-late 2023, primarily due to the Fed’s battle against inflation. And those recession expectations spiked in June 2022, as the University of Michigan’s gauge of consumer sentiment reached its lowest level ever recorded (going back to 1952) and the Conference Board’s consumer confidence expectations index reach its lowest point since March 2013. Meanwhile, economists surveyed by the Wall Street Journal raised the probability of recession to 44% in June — a level the quarterly survey has “seldom seen outside of an actual recession,” the newspaper noted.
To avoid a recession, the Fed must raise rates high enough to tame inflation, but not so high or for so long as to slow or halt economic growth. But it has never managed to do that. It would be a surprise if it managed to do so now, amid the lingering COVID-19 pandemic and the ongoing supply-chain disruptions and unprecedented fiscal spending policies that the pandemic instigated.
So, whether or not a recession comes in 2022, one may still be just around the corner, economically speaking.
- It's not easy to predict exactly when a recession will start, but many analysts are now predicting one to begin in the U.S. in 2022 or 2023.
- Rising unemployment after a previous low can be a reliable leading indicator of an imminent recession.
- An inverted yield curve (when long-term interest rates are lower than short-term rates) is regarded by many as a leading indicator of a recession.
- U.S. homebuyers are extremely sensitive to economic conditions, so falling house prices are a good indicator that the economy is heading for a recession.
- Historically, the Fed’s embarking on a monetary policy tightening cycle has always ended in a recession.
- Given the previous two recessions started without warning, it’s a good idea to recession-proof your business without waiting for indicators to turn negative.
It’s not easy to predict a recession. Some economists like to use historical analysis, looking at the average period between historical recessions and calculating the likely date of the next recession on this basis, much like volcanologists use the average period between historical eruptions as an indicator of when a volcano is next likely to erupt. But economies, like volcanoes, don’t necessarily erupt when economists think they will.
Other economists rely on economic indicators to tell them when a recession is likely to happen. Economic indicators can sometimes show whether a recession is on its way and, if so, when it is likely to hit, especially when two or more indicators flash their signals in alignment. Here’s a rundown of four popular indicators, including how they work and to what extent they can reliably predict recessions. (For a comprehensive discussion of all the commonly cited recession indicators that appear in the news and in economic forecasts, read “11 Recession Indicators for Businesses.”)
Unemployment: A Key Leading Indicator of Cyclical Downturns
Every recession announced by the NBER since the end of World War II has been preceded by rising unemployment. When the unemployment rate switches from falling to rising, a recession usually follows shortly afterward. That turning point is thus a key leading indicator of a recession. (Note that when the NBER declares a recession, it is defined as starting when gross domestic product [GDP] growth starts to slow, not the point at which growth becomes negative.)
The rise in unemployment before a recession is easy to see with hindsight, but detecting it before the event is more problematic. The unemployment rate is subject to short-term variation: It might fall in one quarter, rise in the next and then fall again in the following quarter. And simple rules of thumb, such as “a recession is imminent when the unemployment rate falls to X%,” don’t work because the unemployment rate doesn’t always return to its previous low before the next recession starts. For example, from 1970 through the early 1980s, the unemployment rate at the start of each recession was higher than the rate at the start of the previous recession. As the chart below shows, the underlying trend of the unemployment rate was upward for those roughly dozen years and then downward for the next 20. So it can be hard to determine what level of unemployment indicates that a recession is imminent.
U.S. Unemployment Rate, 1948 – 2022
Some economists like to rely on the NAIRU, the “non-accelerating inflation rate of unemployment.” Economic theory defines NAIRU as that level of unemployment at which economic output is maximized. But as this scholarly paper by economists from Harvard and Johns Hopkins universities explains, NAIRU, too, varies with economic productivity. When the unemployment rate falls below the NAIRU, labor shortages force employers to raise wages and pass the costs on to consumers. Thus, inflation starts to rise, squeezing household incomes and forcing policymakers to raise interest rates. In response to falling sales and rising finance costs, businesses cut production and lay off staff, thus increasing unemployment and reducing economic growth. Thus, unemployment falling below the NAIRU can be a leading indicator of an imminent recession.
Historically, estimates for the NAIRU in the U.S. have been between 5% and 6%. However, identifying the NAIRU is not straightforward. Structural factors in the economy, such as a rising proportion of long-term joblessness with deteriorating employability (a phenomenon known as “hysteresis”) or an aging population with lower productivity, can mean that the NAIRU rises over time. Conversely, between 2015 and 2020, the U.S. enjoyed unusually low unemployment without rising inflation, forcing policymakers to reduce their estimates of the NAIRU.
Former Federal Reserve economist Claudia Sahm has identified a more reliable method for using changes in the unemployment rate to predict recessions. Her economic rule, the “Sahm Rule,” says that recession starts when the three-month moving average unemployment rate rises by 0.5 percentage points or more above its lowest point in the previous 14 months. This rule identifies the unemployment rate turning point in real time using monthly unemployment data from the U.S. Bureau of Labor Statistics; the data is accurate enough to use with little adjustment.
Because the Sahm Rule uses real-time data, it enables policymakers to respond to a recession earlier than an NBER announcement. Sahm suggests that there could be an automatic fiscal policy response when the three-month moving average unemployment rate hits the Sahm Rule trigger point. Introducing fiscal stimulus very early in a recession could prevent the sharp fall in aggregate demand that causes GDP growth to turn negative and thus potentially lessen the severity of cyclical downturns.
Sahm Rule real-time recession monitoring is now included by the St. Louis Federal Reserve in its statistical reporting. And for the 14 months up to May 2022, U.S. unemployment has remained below the three-month moving average. Thus, unemployment was not indicating an imminent recession.
The Yield Curve Can Also Predict Recessions
Governments issue bonds, such as U.S. Treasury bonds, of varying maturities, from a few months’ duration to 30 years or more. Typically, longer-term bonds are cheaper than short-term, reflecting the higher credit and market risks involved with locking up money for a longer period of time. Since higher price means lower yield (aka interest rate), yields on longer-term bonds are thus typically higher than on shorter-term — the longer the bond, the lower the price and the higher the yield. So the so-called “yield curve” normally slopes upward.
But when the economic outlook is deteriorating and uncertainty is rising, investors can start to perceive the short-term risk as higher than long-term. When this happens, short-term yields rise above long-term yields, and the yield curve starts to slope downward for part or all of its length. We call this an “inverted yield curve,” and it’s considered a leading indicator that a recession is imminent.
One way of monitoring the slope of the yield curve is to chart the ratio of yields on two benchmark bonds. The two most often used are the two-year and 10-year U.S. Treasury bonds, although the three-month and five-year bonds are also a popular comparison. If the ratio falls, the yield curve is flattening; if it drops below zero, the yield curve is inverted.
This chart from the St. Louis Federal Reserve maps the ratio of yields for the two-year and 10-year U.S. Treasury bonds since the mid-1970s. The gray-shaded areas are NBER recessions. It shows that an inverted yield curve for this pair of bonds has preceded all NBER recessions shown, save for the brief COVID-19 recession from February 2020 to April 2020. Before that one the yield curve flattened but did not invert.
Yield Curve of 10-Year vs. 2-Year U.S. Treasury Bonds, 1976-2022
The two-year versus 10-year yield curve briefly inverted in April 2022, leading some analysts to predict that a recession may be coming in the U.S. within a year.
Homebuilding and Buying Trends Can Presage Recessions
The rate of homebuilding can be a good leading indicator of recessions. As the chart below shows, new housing starts typically fall shortly before a recession starts.
New Housing Starts, 1959 – 2022
However, housing starts can vary for reasons that have nothing to do with economic conditions. Sometimes homebuilding falls but no recession follows, as was the case in 1965 when housing starts collapsed. And sometimes a recession occurs despite little change in homebuilding. For example, the rate of housing starts to rose just before and during the first half of the 2001 dot-com recession.
A more reliable indicator is property prices. History shows that U.S. homebuyers are extremely sensitive to changes in economic conditions. As a recession approaches, the rate of homebuying declines and prices start to fall. House prices have fallen before every recession since 1990, including the brief recession between February 2020 and April 2020. Thus, when property price indexes such as the Case-Shiller Index start to fall, recession warning indicators flash red.
As of June 2022, however, year-over-year growth in housing prices remained high, suggesting that a recession is not imminent.
S&P/Case-Shiller U.S. National Home Price Index, 1988 – 2022
Interest Rates Can Be Leading Indicators of Recession
Some economists believe that the countdown to the next recession starts when the Federal Reserve commences a period of monetary policy tightening. When the Fed raises interest rates to calm an overheating economy, GDP growth slows and can even fall. Thus, since the NBER measures recessions from the peak to the trough of GDP growth, Fed monetary policy tightening always results in an NBER recession. The next chart shows how NBER recessions follow from sustained rises in the federal funds rate. Thus, a rising federal funds rate is a good, though not always useful, leading indicator of a recession.
The Federal Funds Rate, 1954 – 2022
The problem with using interest rates as a leading indicator of a recession is not knowing how long it will take for the economy to enter the recession after monetary policy tightening begins. Referring to interest rate increases that the Fed began in early 2022, Deutsche Bank strategist Jim Reid explained that, “The median and average time to the next recession is 37 and 42 months after the first hike, so that takes us to July 2025 and December 2025, respectively.” But, he noted, it could be sooner: “The earliest gap over 13 cycles is 11 months, and that would take us to May 2023.”
Could the Next Recession Begin in Fall 2023?
It’s hard to predict exactly when the economy will enter the next recession. But many economists now think one could start in fall 2023, and for a number of reasons.
First, inflation is now at its highest level in a quarter century. The Fed is signaling a fast pace of interest-rate rises over the course of 2022 and 2023 to get inflation under control, and it’s also planning to sell off some of the assets it has purchased under its quantitative easing programs. Many analysts think that such sharp tightening could push the economy into a recession, as it has done every time before since World War II.
Second, global economic conditions are worsening because of the war in Europe and the COVID-19 pandemic continuing to affect countries crucial to global supply chains, such as China. In its World Economic Outlook for April 2022, the International Monetary Fund (IMF) cut its prediction for global year-over-year growth in real GDP from 6.1% in 2021 to 3.6% for both 2022 and 2023. The IMF’s estimations of U.S. GDP growth were 5.7% in 2021, 3.7% in 2022 and 2.3% in 2023.
Third, although most analysts didn’t see the brief yield curve inversion in April 2022 as indicative of an imminent downturn, there’s still not much difference between two-year and 10-year bond yields. This suggests that the current U.S. economic boom will come to an end by 2024.
These are the conditions causing many economic experts and institutional investors to predict that the U.S. will enter a recession in fall 2023.
The Next Recession May Be Postponed, Not Eliminated
Recessions seem to be an inevitable feature of the U.S. economy. Since World War II there have been 12 recessions, so that’s on average one every six to seven years. If history is any guide, then even if the next recession doesn’t start in fall 2023, it’ll be along within the next two years or so.
Economic theory is divided on whether recessions are inevitable. Some economists say that recessions stem from policy errors, such as the Fed pouring too much money into the economy and then having to raise interest rates abruptly to stem rising inflation. If policy errors can be avoided, recessions need not happen — ever. However, even the economists who hold these beliefs point out that, since policymakers don’t have perfect information or perfect foresight, mistakes are likely and, therefore, so are recessions.
To minimize the risk of mistakes and thus keep the economy on a steady path, some economists would like the Fed to adopt an automated rules-based approach to monetary policy. Others, however, say that a rigidly automated approach would be insufficiently flexible to respond to extraordinary shocks such as the COVID-19 pandemic.
Still other economists hold that the economy naturally goes through cycles of expansion and contraction, known as “business cycles.” These cycles can be driven by fluctuations in the supply of credit, which in turn responds to monetary conditions created by the Fed. Or they can be driven by fluctuations in saving and spending behavior as business, investor and consumer confidence varies, often in ways that are hard to explain; economist John Maynard Keynes called this “animal spirits.” In contrast, “real business cycle” (RBS) economic theorists say that cyclical fluctuations are caused by technological changes that affect productivity.
Some economists, notably those of the “Austrian” school of economics, believe that recessions are necessary to clear out the “dead wood” of underperforming businesses and poor investments, so the economy can embark on vibrant growth again.
But whether or not recessions are inevitable, it’s wise to recognize that they do happen — and to be prepared for them.
5 Ways to Prep Your Business for a Recession
Signs show that the next recession will begin in the next year or two. And even if it doesn’t happen quite so quickly, it’s going to come along at some point relatively soon. So it’s wise to be recession-ready. Here are five ways you can prepare your business for a recession.
Carefully Manage Invoicing
Maintaining good cash flow is crucial to surviving a recession. Many businesses fail not because the business itself is unsound, but because customers don’t pay on time and credit control is too lax. So make sure that your customers are invoiced promptly, payments are recorded as soon as they arrive and late payments are pursued efficiently. Offer credit only to customers with good credit scores.
Remember, though, that recessions don’t last forever, and businesses need loyal customers. If previously good customers get into difficulty with payments, it can be worth renegotiating terms with them to help them survive the recession, too.
If a business’s cash flow is heavily dependent on a small number of customers, it can look for ways to broaden and diversify revenue streams so that it won’t suffer a serious cash flow disruption if one customer gets into difficulty. For example, it could market its products to a wider customer base and offer discounts to new customers.
It’s worth linking invoices and receipts directly to the business’s accounting software so that it can monitor cash flow day-to-day.
Manage Payment Terms
Tight payment terms can be a source of business fragility. Businesses need the flexibility to extend supplier payment terms if necessary to protect cash flow in a downturn. So an important part of preparing for a recession is reviewing and renegotiating supplier contracts — not just for lower prices, but for flexibility in payment terms.
However, good relationships with suppliers can be key to a business’s survival. It’s worth taking the time to work with suppliers so that they understand your business constraints and can help you get through difficult times. It may not always be wise to jump ship if a new supplier offers lower prices. Consider whether the existing supplier offers the flexibility and understanding that the business might need to get through difficult times.
Remember, though, that suppliers can also get into difficulty in recessions. Be prepared to be flexible about payment terms if an important supplier is struggling with cash flow. And have contingency plans for supplier failure so you can continue to meet customer needs with as little disruption as possible.
Build a Cash Reserve
Businesses, like households, need “rainy day” savings to cover unexpected expenses or shortfalls in revenue. When the business is humming along and profits are good, therefore, it’s sensible to build up a cash reserve to see the business through more difficult times. A good rule of thumb is to have enough cash available to cover 90 days’ worth of expenses.
If the business has debt, you need to ensure that a downturn won’t put you in danger of breaching the conditions imposed by lenders. As cash flow and revenue often come under pressure in a recession, it may be worth trying to renegotiate any terms that require the business to maintain a minimum level of cash flow and/or EBITDA. If this isn’t possible, then consider reducing or eliminating debt.
It’s normal for sales to fall in a recession, so inventory tends to rise. Establishing fast and efficient supply chains so that inventory levels remain low while sales are strong can help prevent excessive inventory from building up when sales decline. That will reduce the need for heavy discounting in a downturn. This is particularly important when products have a relatively short shelf life.
Drop Unprofitable Products/Services
When a recession hits, business lines that don’t contribute much in the way of profits can quickly become money pits. So it’s worth getting rid of them before they start draining cash. Review and rationalize business lines, winding down or selling any that are performing poorly or aren’t core to the business.
However, if the business has a product line that is currently bumping along the bottom but you believe is key to the business’s future, then now is the time to invest in it. Upgrade the relevant machinery, hire new staff, train existing staff and rationalize and streamline related business processes. You want it to be firing on all cylinders before the next recession hits.
Improve Performance With Real-Time Metrics in NetSuite Financial Management
Recession-proofing any business requires a really good handle on the five key areas of business performance information listed above: invoicing, payment terms, cash flow, inventory and profitability. With NetSuite Financial Management software, business leaders can monitor these areas in detail day-to-day, matching budgets against forecasts and enabling them to identify the areas where the business needs to build resilience.
Economists use a combination of historical analysis and indicators, such as the unemployment rate, yield curve, housing prices and interest rates, to help them identify when the next recession will hit. Many now think the next recession will start in fall 2023 or shortly thereafter. But recessions don’t necessarily come along when the experts think they will, though they always happen eventually. And the last two recessions both happened without warning. So recession-proofing your business now can help protect it from an expected — or unexpected — downturn.
Recession Prediction FAQs
Why is it difficult to predict a recession?
Although recessions have historically happened on average every six to seven years in the U.S., there’s a lot of variation in the time span. Some analysts like to use historical analysis to predict when a recession is likely to happen, but recessions don’t always turn up when people expect. For example, there were separate recessions in 1980 and 1981 to 1982, but the next recession didn’t appear until 1990. Then there was an 11-year gap until the dot-com recession of 2001. So predicting when a recession is going to happen can’t be done from historical analysis.
When indicators of recession such as an inverted yield curve or falling house prices say that a recession might be coming, oftentimes the recession never actually materializes. This is because these indicators respond to a range of conditions, not all of which necessarily mean an economic downturn. For example, an inverted yield curve reflects fears about the future in financial markets, which, as the economist John Maynard Keynes wryly observed, can be irrational.
Can a recession be predicted?
Although some indicators appear to reliably predict an imminent recession, in practice they can never predict it with 100% certainty. This is because the way people react to indicators can prevent what the indicators predict from actually happening. Goodhart’s Law, named after the British economist Charles Goodhart, says, “When a measure becomes a target, it ceases to be a good measure.” For example, Claudia Sahm, an economist at the U.S. Federal Reserve, says that if the government responds quickly enough to a “Sahm Rule” trigger, the sharp fall in GDP that most people regard as a recession — and that the Sahm Rule trigger predicts — can be prevented. (The economic rule that bears Sahm’s name says that a recession starts when the three-month moving average unemployment rate rises by 0.5% or more above its lowest point in the previous 12 months).
How do we know recession is coming?
We can never know for certain that a recession is coming, but there are indicators that can predict that one is likely. These indicators include rising unemployment, an inverted yield curve, falling house prices, falling residential construction starts, rising interest rates, falling sales and declining business and consumer confidence as measured by surveys conducted by the U.S. Bureau of Labor Statistics and IHS Markit. Some indicators are more reliable than others: For example, rising unemployment is generally regarded as a good indicator of an imminent recession. And when many indicators are flashing red, a recession is probably odds-on. However, no indicator or combination of indicators can predict a recession with 100% certainty.
How accurate are economic predictions?
The stature of economic predictions took a considerable beating in 2008, when a financial crisis and deep recession hit the world out of the blue. Few economists had predicted this event, and those who predicted a crash had been ridiculed. On a visit to the London School of Economics in November 2008, the Queen of England, Elizabeth II, asked why no one had seen it coming. This was a question that the economics profession asked itself many times over the next few years. Many economists concluded that models of the economy that excluded the amplifying role of banking and credit creation were unable to predict financial crises, and they started adding the financial sector to their economic models. However, economic predictions for many economies after the 2008 financial crisis proved overly optimistic. For example, the International Monetary Fund (IMF) repeatedly predicted a recovery for the Greek economy as it slid further and further into an economic depression, eventually shrinking by over a quarter. In 2020, a paper by a Japanese researcher concluded that long-term macroeconomic predictions are unreliable and biased upward — in other words, economists tend to predict better outcomes for the economy than turn out to be the case.
What is the Sahm Rule in economics?
The Sahm Rule, conceived by U.S. Federal Reserve economist Claudia Sahm, says that a recession starts when the three-month moving average unemployment rate rises by 0.5 percentage points or more above its lowest level in the previous 12 months.