Could we talk ourselves into a recession?

Could a recession become a self-fulfilling prophecy?

Until late last week, the U.S. economy was viewed as slowing from its torrid, post-pandemic pace but still on solid footing and at little risk of slipping into a downturn.

Suddenly, a disappointing July jobs report – following some weak data on manufacturing, construction and jobless claims - set off a steep market sell-off and pervasive recession talk. Adding to market tremors was an ill-timed Bank of Japan interest rate hike.

Stocks rebounded Tuesday and through mid-day Wednesday, easing, though not dispelling, worries of a downturn. In early-afternoon trading Wednesday, The S&P 500 index was still 4.2% off its close a week ago.

How does low consumer confidence cause a recession?

The episode provides a stark reminder that sharp market swings can affect consumer and business confidence, which in turn can impact the real economy.  In other words, if people believe the economy is wobbling, they may pull back spending and companies may curtail hiring and investment, causing the economy to teeter even if its fundamentals were previously sturdy.  

“Ultimately, a recession is a loss of faith,” says Mark Zandi, chief economist of Moody’s Analytics. “Consumers lose faith that they’re going to hold onto their jobs and cut back spending.” Businesses see their sales fall and stop hiring or lay off workers in a “self-reinforcing vicious cycle.”

There’s also a more tangible impact: A potential loss of cash. If stocks tumble enough over time, it makes consumers feel less wealthy and they’re likely to spend less, says Kathy Bostjancic, chief economist at Nationwide.

Such a negative spiral hasn’t happened and the recent turmoil appears to have abated for now. It would take a longer, more enduring slide in stocks to spoil the narrative of an economy that’s slowing but not crashing, Bostjancic says. Still, she says, markets remain volatile and another dose of bad economic news - or perhaps a Federal Reserve that cuts rates less than investors hope next month- could trigger further jitters.

Will the U.S. have a soft landing?

Last week’s flurry of feeble economic data at least raised some questions about “the idea that we’re on a glide path to a soft landing,” says Bostjancic. A soft landing is shorthand for the widespread belief that the Federal Reserve’s rate-hiking campaign in 2022 and 2023 beat back high inflation without tipping the economy into recession.  

To be sure, the economy has some trouble spots. U.S. employers added just 114,000 jobs last month, well below expectations for 175,000 gains, and the unemployment rate rose from 4.1% to 4.3%, highest in nearly three years, according to last week’s employment report. One gauge that tracks the rise in unemployment the past year is already signaling the U.S. could be in a recession. And hiring has dipped below pre-COVID levels.

Meanwhile, manufacturing activity shrank again in July, falling to an eight-month low. Consumer spending, the economy’s main engine, is slowing. And credit card debt is at a record high and delinquencies are historically elevated, mostly because of the struggles of low- and middle-income households. And Americans’ pandemic-related savings largely have run dry.

Many top economists believe the Federal Reserve has left its key interest rate at a 23-year high for too long even as inflation has eased, causing consumers and businesses to curtail borrowing and spending.

“There are some reasons to be nervous,” Zandi says. “The Fed is late to the game.”

What are the chances of the economy crashing?

Yet there are also reasons for calm. Monthly job growth averaged a healthy 218,000 the first half of the year, and a solid 168,000 from April through June. Although the Labor Department said the July job totals weren’t affected by Hurricane Beryl in Texas, research firm UBS notes that 436,000 people were unable to work because of weather last month, up from an average 33,000 in July over the past 24 years.

In other words, last month’s paltry jobs total may have been a blip.

The economy grew a robust 2.8% in the second quarter. And while consumer spending growth is downshifting, it’s still solid. Household debt payments as a share of disposable income have increased the past three years but they’re still historically low. And total household wealth is up 37% since the start of the pandemic, UBS notes.

Zandi puts recession odds at 33%, up from 25% early this year.

“The economy is slowing but not headed over a cliff,” Morgan Stanley wrote in a note to clients.

What happened to the economy in 1990?

Other recessions have been caused, or amplified, by negative consumer and business sentiment.

In a 1993 article in the American Economic Review, Stanford University economist Robert Hall wrote that he couldn’t find an obvious cause for the 1990-91 recession.

“There seems to have been a cascading of negative responses during that time, perhaps set off by Iraq’s invasion of Kuwait and the resulting oil-price spike in August 1990,” Hall wrote, according to a 2019 study by the Federal Reserve Bank of Richmond. “Consumers responded to the negative forces as they would to a permanent decrease in their resources.”

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The opposite happened during the March-November 2001 recession, which was set off by the dotcom crash and intensified by the 9/11 terrorist attacks. Economists expected the downturn to last much longer as people stayed home because of fears of another attack.

Instead, “the public resolved to defy the attackers by carrying on with life as normal,” Nobel prize-winning economist Robert Shiller wrote in his 2019 book, Narrative Economics, according to the Richmond Fed paper, titled, "Talking Ourselves into a Recession."

“Pessimistic expectations can generate recessions,” economist Jess Benhabib of New York University wrote in a 2019 article, in The Economic Journal, the Fed paper notes. “Optimistic expectations can generate booms.”