If you follow business news, or even political news where the debate weapon is the trajectory of the economy, you’ve likely picked up on the opinion that the U.S. is headed into a recession.  This, after all, has been the consensus projection for over a year.  

These predictions are a lot like the axiom “live each day as if it were your last, and one day you’ll be right.”  Economies, even the strongest ones, do not grow in a constant upward path. Business cycles and external shocks happen, eventually, causing contractions.  Not all recessions are major, and some are even over before they are officially declared.  Eventually, however, they do happen.

Economics is based on the premise of “rational expectations”.  It’s hard to form rational expectations if you don’t actually understand what all terms and statistics being thrown about actually mean.

There are two main tools that the federal government uses to manage the economy, monetary and fiscal policy.  Monetary policy involves the setting of interest rate targets, managing the money supply by buying or selling bonds, as well as setting reserve requirements for banks which also control the amount of money added to or taken out of our system.

Fiscal policy involves spending on behalf of the government, and the borrowing that is required to finance deficits.  In theory, it could also mean bringing in surplus tax revenues during good times, but the last time we ran a small budget surplus was 2001, and we’ve operated with a net national debt since 1846.  For those that knock Keynesian economics, note that we haven’t tried running surpluses during good times consistently for almost 200 years.

What has been keeping the economy running relatively strong over the past year is the fact that consumers, on average, are still financially better off than they were prior to the pandemic.  Consumer spending is generally more than 70% of the U.S. economy, so when consumers spend money, the other items usually fall into place.

The problem when you’re trying to fight inflation, however, is that having consumers keep spending and businesses investing to meet their demand keeps prices increasing.  It further hurts the fight when the government spends more than it is taking in, adding additional stimulus to an economy that doesn’t need it.

The Federal Reserve has now been raising interest rates for over a year, but for most of that year, interest rates were still low enough to be “accommodative”, which is fed speak for simulative.  Only in the last few months have “real” interest rates – the stated interest rate minus the rate of inflation – become restrictive.  This matters because while consumers have seen their cost of borrowing money go up with their costs of goods for a while now, only recently has it costs more to borrow money than the value of that same money would be at the time it was repaid.

Just as businesses and some consumers started to adjust their plans on this newer, restrictive policy, the collapse of several banks sent a warning signal to consumers, businesses, and government.  There were stresses within the banking system that had not been previously accounted for, and banks may need to pull back on their lending to preserve capital in preparation for loan losses.

What does this look like, in practice?  Capital One – known to most as a credit card company, decided to abruptly end their business of loaning money to car dealers for inventory.  Citizens Financial Group has publicly stated it will pull back on some forms of consumer lending, including car loans.  Loans to “subprime” customers – those with credit scores that would not meet most bank’s traditional underwriting standards, are evaporating quickly.

One large Georgia based used car dealer – U.S. Auto Sales – abruptly closed all 39 of its stores as it seeks to find financing to re-open.  The dealership relies heavily on sales to customers in the sub-prime category. 

This is what contraction looks like from an anecdotal level, before anecdotes become statistics.  Economists look at what is happening to buyers and sellers at the margins – these are the first buyers and sellers to change habits in response to outside, macroeconomic changes.  

This is also a reason why you see that those without savings or other safety nets are considered to be hardest hit during economic downturns.  When lending standards get tighter, it is those barely able to qualify for loans – those in the sub-prime category – who are forced out of the market.

While the Fed’s monetary policy is now working its way through the system, another perhaps even bigger shock may be headed toward GDP growth.  The Federal Government will hit the debt ceiling late spring or early summer, which has provided the opportunity for a partisan standoff over spending.

It’s unlikely that Republicans will pass a debt ceiling bill without some cuts to spending.  While this may be optimal for the long term health of the US economy, a drop in federal spending – by definition – results in a lower GDP number in the short term.  This showdown will happen just as the lag from the Federal Reserve’s restrictive interest rates are fully kicking in.

If you want to know why so many people are nervous about the economy despite all current indications that consumer spending remains strong, this is it.  Banks are tapping the brakes on consumers and businesses.  The Federal Reserve continues to tighten rates.  And those who need to make decisions based on government action or inaction have no clear path until the debt ceiling and related spending issues are decided.