U-M economists expect ‘mild recession,’ though auto sector strength should curb worst effects in Michigan

November 17, 2022

A mild U.S. recession is likely in store to whip inflation, though there’s hope the strength of the automotive sector will shield Michigan from the worst effects of that potential downturn.

University of Michigan economists say inflation is a key driver of their annual U.S. Economic Outlook report, released Thursday at the university’s 70th annual Economic Outlook Conference. If “the October surprise slowdown” in inflation proves durable, the Federal Reserve will have a chance to deliver “a soft landing.”

Still, a topsy-turvy global economy with many moving parts both encouraging and concerning leaves them hesitant to “breathe sighs of relief” without some consistent improvement.

“We expect monthly inflation to tick back up in the next few months,” the economists say in their outlook. “As a result, we judge that the Fed will have to keep raising the federal funds rate through mid-2023, and it will likely take a mild recession to drive inflation down for good.”

U-M economists expect the Fed to hold the federal funds rate flat during the second half of 2023, as inflation gradually falls and joblessness slowly rises. By early 2024, they envision the Fed to start cutting rates again, which would help to stabilize the job market.

On a related note, the report notes the “deep shock” in the U.S. housing market—not surprising given the doubling of the 30-year fixed mortgage rate over the past year. That trend is unlikely to reverse until mortgage rates peak and existing home prices are done falling.

Other signs of worry come from Fed data that show tightening lending standards for commercial and industrial loans, as well commercial real estate development. Manufacturing activity is also in jeopardy, deterioration driven by ongoing declines of goods consumption and a significant appreciation of the dollar over 2022.

On the plus side, broad measures of labor market activity remain strong: Employment growth has been robust lately and jobless claims remain low despite layoffs being a mainstay in the headlines. Given the generally soft outlook, economists say in the report that they expect job gains to slow gradually over the coming months.

“We think the current momentum in the labor market and consumption spending is strong enough to keep the economy from turning over for a few quarters,” said Daniil Manaenkov, U.S. forecast lead at U-M’s Research Seminar in Quantitative Economics. “But as the housing market contracts, businesses turn cautious due to deteriorating economic projections, banks tighten credit further and households increase their savings, the economy’s momentum will fade.”

Another potential beacon of hope comes in the auto sector, where sales of new light vehicles might be ready to boost growth: Both sales and the pace of production have improved recently. Rising inventory-to-sales ratios should help meet the pent-up demand and could curb price inflation, according to the report.

In Michigan, the researchers say, the backlog of demand caused by supply chain shortages during the pandemic recovery could “prove to be a silver lining as the economy cools.” Couple that with the industry’s shift to electrification, which should support near-term labor demand with investments in assembly and battery production plants.

Still, they note, the ride may not be smooth across all economic lanes: The state’s nonautomotive manufacturing could be hurt by the strong dollar, and high mortgage rates appear primed to stall residential construction activity.

“Nonetheless,” the Michigan Economic Outlook report says, “if the auto industry is able to avoid major potholes ahead, it could end up towing the state’s labor market forward along with it.”

The likely recession is expected to spur an increase in the state’s jobless rate, from 4.1% during the past summer to 4.7% in early 2024. If the Fed is successful in taming inflation, as the economists expect, real disposable income per capita will climb slightly above its pre-pandemic level in the next two years.

“We are forecasting continued job growth here in Michigan, even as the national economy slips into a mild recession,” said Gabriel Ehrlich, director of RSQE. “Experienced observers of the state economy know that is not the typical pattern.”

Overall, the state of the economy in Michigan and the rest of the U.S. is challenging to interpret because of contradictory signals, the economists say. The economic picture reveals ongoing expansion of economic activity alongside signs of weakness that suggest the economy will mildly contract in the second half of next year.