Center for Economic Analysis

MSU Economic Outlook for Michigan and for the Lansing-East Lansing Metropolitan Area

Over the last few years of creating the annual MSU Economic Forecast, I’ve learned to appreciate how uncertainty impacts our ability to plan as individuals and as businesses. These last few years have seen significant economic disruptions including COVID19, shifts in consumer behavior, prolonged supply disruptions and persistent inflation, to name a few. These challenges make forecasting the economy challenging. Add to that, many of the tried-and-true relationships that economists rely on as gauges of the health of the economy no longer hold true. We’ll discuss the current state of the U.S.-national economy and key measures and what these measures convey about the health and direction of the national economy.

The Federal Reserve and Inflation

A lot has been said about inflation and for a long while, it seemed the Federal Reserve Bank’s usual tools for restricting the money supply were powerless to curtail the relentless march of prices. In months following the pandemic, the Federal Reserve Bank pursued a policy of quantitative easing – injecting dollars in the economy through the purchase of U.S. government securities. Whether caused by the Fed’s aggressive easy money policies or by constraints on supply, a sharp increase in prices ensued and much of the Fed’s policy focus since has centered on containing the resulting inflation.

The figure below shows two common measures of inflation, both measured in percentage growth from the prior year. The blue line is the Consumer Price Index (CPI) and is the broadest measure of inflation, representing the change in the cost of the typical basket of goods and services urban households consume. The red line, however, is the Federal Reserve Bank’s favorite measure of inflation. This measure ignores the volatile influence of food and energy prices on the CPI and is often referred to as the measure of core inflation. The Feds target rate of inflation is thought to be 2% annually and accordingly to latest figures, core inflation remains elevated from that target but are definitely off its high of 6.6% in September of 2022. So, while inflation appears to be heading in the right direction, 4.7% core inflation is likely to spark further rate hikes by the Federal Reserve Bank.

The Discount rate is the primary tool the Federal Reserve Bank uses to communicate its intent on the economy. If the intent is to accelerate economic growth, they lower the discount rate thereby making it less costly for banks to borrow money. On the other hand, if they believe the economy is overheated, they raise the cost of borrowing money by raising the discount rate. As inflation is a product of an overheated economy, the intent of raising rates is to reduce consumer and business spending on goods and services that are in scarce supply. Due to a 2003 change in how the Discount Window for borrowing works, the discount rate over time is provided by two overlapping series in the graph below. Though Federal Reserve Bank rate hikes have slowed over the last year they appear poised to persist due to persistent inflation. It is our contention though that inflationary pressures will continue to abate and that the Federal Reserve Bank will follow let go of future rate hikes in the coming year, barring any unforeseen changes in the economy.

Will the Next Recession Reveal Itself?

As many prior recessions were preceded by monetary tightening, most commentators are asking when will the next recession hit. It is generally hoped that the Federal Reserve Bank will be successful in orchestrating what is called a “soft landing” of the economy. What we mean by a soft landing is a case where the economy transitions from an overheated state with inflationary pressures to one of price stability without causing a recession. This is harder than one may think, as the tools available to the Federal Reserve Bank are imprecise, as are the measures of the health and direction of the economy.

One leading indicator has an unprecedented track record of predicting recessions. That is the yield curve. The most common version of the yield curve is the yield (implied rate of interest) on 10-year Treasuries minus the yield on three-month treasuries. To be clear ten-year and three-month treasuries are U.S. government issued bonds, or securities, with expiration, or payouts, ten years and three months, respectively, in the future. If investors believe a recession is on the horizon, they anticipate future bond yields will decline. Rather than wait for yields to decline, they will bid up the price of long-term securities, which has the effect of reducing the implied yield, or return, on those bonds. When this happens, the yield on long-term securities will decline relative to short term securities. In the extreme case, the yields on long-term securities will be lower than that on short-term securities causing an inverted yield curve. The figure below shows the yield curve (10-year minus 3-month treasury yields) over time, indicating periods of yield curve inversion as negative values. We can see that, at least from 1982, each recession (shaded region) has bee preceded or coincided with a yield inversion. Generally, the inversion is shallow or short-lived. But then we get to October of 2022, where the yield curve turns unprecedently negative and persistent. Yet no recession has occurred. This leads many commentators to assume that a recession is less a matter of “if,” but one of “when.”

INVENTORIES

Economists also look to inventories as a leading economic indicator. However, changes in business inventories can have ambiguous implications. If consumers unexpectedly decrease expenditures, businesses may be slow to respond and continue producing – thereby creating unplanned inventories. Alternatively, unexpectedly low inventories suggest that businesses under estimated consumer demand and will have to ramp up future production. That is, low business inventories counter-indicate a looming economic slowdown.

In the graph below, total business inventories declined before the 2001 and 2020 recessions. With respect to the Great Recession of 2008, inventories continued to build until the Fall of 2008 before dropping. The record is a bit mixed, showing that an off-trend runup of inventories preceded all three recessions, but an increase in inventories alone is not a reason to expect a recession. However, in the fall of 2022 a pattern emerges that resembles the leadup to the 2001 and 2020 recessions.

Dividing inventory levels monthly sales provides a different perspective. For instance, the graph below shows that relative to the volume of sales, inventories advanced begore and during the prior three recessions. This was much more pronounced during the 2020 recession despite widespread reports of stock-outs on many categories of consumer goods.

We can further break inventories to sales ratios out into that of retailers, wholesalers and manufacturers. Overall, inventory sales ratios do not provide a convincing argument for or against an impeding economic correction. However, manufacturing and wholesale inventories are persistently high relative to sales, while retail inventories are suppressed. We do not read much into the low retail inventories, as shifts in consumer shopping behaviors and retail innovations brought about in the wake of the pandemic have led to profound shifts in how retail is done.

AUTO INDUSTRY

It is hard to talk about Michigan’s economy without discussing the automobile sector. Just under 20% of U.S. employment in transportation equipment manufacturing is in Michigan making it a key driver of the state’s economy. Purchasing a new vehicle can be a significant financial commitment. Accordingly, consumers may be hesitant to purchase new automobiles and light-duty trucks if they are concerned with the direction of the economy. As consumers’ purchasing habits reflect their perception of the economy, vehicle sales may be considered an early indicator of the future direction of the economy. As seen below, new vehicle sales tend to taper off before a recession, but it is difficult to separate the noise from the trends. Both production and sales of new motor vehicles suggest further economic growth.

While manufacturers have a healthy inventory of motor vehicles and parts on hand, the current UAW strike will quickly draw down those inventories at the current rate of sales. Since the pandemic, consumers have faced unquestionably higher new car prices, and the UAW strike will likely delay any reprieve in the near future. For the immediate-term consumers will likely bear the brunt of the UAW strike with fewer incentives and deals on new and used cars. Should the strike persist and expand to last in excess of four to six weeks, it may start having spillover effects on first- and second-tier suppliers.

CONSUMER-DRIVEN GROWTH

Consumers have largely kept the economy afloat over the last two years. Personal consumption expenditures make up about two-thirds of U.S. Gross Domestic Product – a measure of the overall size of the economy. Accordingly, consumers’ perception of the economy can dictate growth or a recession. Despite the brief pandemic-spurred recession of 2020, the U.S. has experienced an unprecedented spate of growth. The economic expansion following the great recession lasted 128 months, making it the longest uninterrupted expansion in history. Joblessness soared during the recession, but the government intervened with employment incentives and direct stimulus payments to households, and other safety-net policies that not only helped households remain solvent, but also boosted personal consumption expenditures. Months later, consumer spending is the primary source of economic stability as households continue to draw down elevated savings generated from the combination of government stimulus and savings brought on by COVID19 restrictions. However, that spending is starting to taper off, as consumers start to reconcile mounting levels of debt. 

The combination of stimulus checks, expansion of social safety net programs and restrictions on indoor and outdoor gatherings led to unprecedented personal savings. Consumers have since been spending down that savings and then some, such that current rates of personal savings are well below that of the decade leading up to the pandemic.

To support their spending spree, consumers increased borrowing, as shown below. Combined with low savings, high credit utilization can expose consumers to added risks of an economic downturn. Equally so, we may see consumers pull back further on spending to replenish savings and pay back debt.

As noted, consumers have been resilient in this economy. Despite the ongoing spending spree, consumer confidence hit an all-time low of 50.0 in June of 2022 but has since reversed course. While remaining tepid, the University of Michigan Consumer Sentiment series shows increasing consumer confidence and may signal that consumer expenditures may remain strong through 2024. Consumers will face some headwinds. Student loan payments resume October 1 on some $1.77 trillion in outstanding student loans. About 43.5 million Americans are expected to start repaying student loans, reducing funds for spending by about $150 billion.  

CLOSING

Before we close, we should look at one last measure of the economy. We discussed Gross Domestic Product (GDP), and the components making up GDP. As a measure of the value of all final goods and services purchased, GDP is perhaps the broadest measure of the health of the economy. However, there is more than one way to measure GDP. If dollar spent by one is a dollar of income for another, the converse of GDP is Gross Domestic Income, or GDI. GDI and GDP should measure the same and come out with the same value, but different data are used in generating these measures and they do not always agree. As shown below, the GDI measure of the current economy provides a less optimistic picture of the current economy than GDP. Both GDP and GDI measures are subject to revision when new data arrive. The question is, will the revisions favor the GDP or the GDI estimates?

In closing, consumers have kept this economy vibrant despite facing headwinds. Low savings, elevated rates of interest on consumer borrowing, and the return of student loan payments will test their resolve. The Federal Reserve Bank recently indicated they are nearing the end of their rate hikes – hinting that just one more may be required. As has been true for some time now, indicators point to an impeding economic slowdown, but when? The MSU Economic Forecast is that a recession will not materialize in 2024, barring any unforeseen events like the further escalation of conflicts in the Ukraine and North Africa, a prolonged UAW strike, etc. It may even be safe to say that the Federal Reserve Bank has orchestrated a soft landing for the economy, though core inflation must be contained before the Federal Reserve Bank relinquishes it’s hold on interest rates.

September 21, 2023