U.S. Economy: Banking crisis will lead to contraction of the economy

The U.S. economy is in turmoil and exposed to high risks. The banking stress, the debate about raising the debt ceiling, higher interest rates, geopolitical tensions, and the weakening global economy are likely to lead to a recession this year.

In the United States, gross domestic product increased by only 0.3 percent in the first quarter of 2023 compared with the previous quarter (annualized 1.1 percent). While private consumption still grew robustly, business investment expanded only slightly. Business inventories have decreased, and the high level of consumer demand was probably serviced to a not insignificant extent by inventories. The downward trend in housing investment continued at a somewhat slower pace. This development is also likely to be a consequence of high inflation and the monetary policy tightening that began in spring 2022. Positive impetus for the US economy still came from foreign trade in the first quarter of 2023; exports increased more strongly than imports.

At the end of the first quarter, the onset of the banking crisis with the collapse of Silicon Valley Bank, followed by others in recent weeks, significantly increased economic risks. Lending has already been reduced and uncertainty among companies and households has increased noticeably. Economic development indicators also recently pointed to an economy in a crawl. The purchasing managers’ index is below the expansion threshold of 50, but at least industrial production has increased weakly of late. Consumer sentiment has improved somewhat compared with the low point in summer 2022, but is still pessimistic.

In the current year, the US economy will expand without much momentum. In addition to higher interest rates and lower real wages, problems in the banking sector have been weighing on the U.S. economy since the collapse of Silicon Valley Bank in mid-March; lending to companies and households is likely to decline even more than was already to be expected as a result of the interest rate hikes. Although a full-scale financial crisis like the one in 2008 seems unlikely at present, the risks of such a scenario are heightened. Against this background, consumer demand will probably initially decline somewhat in the coming quarters before small positive rates can be expected again, especially in the coming year. Private consumption is at least being supported by the low unemployment rate, which was only 3.6 percent in February. The weak momentum of private consumption and higher interest rates mean that no growth can be expected in business investment either; here, too, there is likely to be an initial contraction. This development is also dampening imports. As exports will also only increase moderately due to the slow recovery of the global economy, the trade deficit will remain roughly constant.

There is currently no tailwind for the US economy from economic policy. In a few weeks’ time, American politicians from both parties will have to agree on an increase in the debt ceiling. It can be assumed that such a bipartisan compromise will include cuts in social programs, for example. The Inflation Reduction Act, which was passed in the summer of 2022 with a volume of just under $400 billion and is intended in particular to promote investment in renewable technologies, is spread over ten years and will have a noticeable but minor impact on the economy in the individual years. Monetary policy has rapidly become less expansionary over the past year. To be sure, inflation has gradually declined with falling energy and food prices in the fall and winter. But core inflation in particular, which excludes energy and food prices, remains in a range well above the central bank’s average two percent target. For monetary policy, an increasing dilemma is emerging between fighting inflation, financial market stability and arguably increasing concerns about economic development.

All in all, according to my baseline scenario, the U.S. economy will probably go through a – hopefully – mild recession in the current year, but will still grow by 0.7 percent on average for the year. A growth rate of only 0.6 percent is also expected for 2024. Inflation will still be significantly elevated at 3.9 percent in the current year and will not fall below two percent until 2024. Unemployment is expected to rise gradually over the coming quarters.

I continue to be rather pessimistic about the economic outlook. Rapid interest rate hikes and problems in the banking sector could well trigger a more severe economic crisis than I am assuming here.

Email: info@eagle-economist.com

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