Watch for These Signs of Recession As the Fed Keeps Rates Elevated

A couple of weeks ago, the Fed did as was expected and kept the overnight rate unchanged. No surprise there.

The Fed cited elevated short-term inflation risks, and they’re maintaining their cautious stance, which means, interest rates will be higher for longer, Marcus & Millichap’s John Chang shared this week during his firm’s trends analysis video.

“Now, the risk of keeping rates elevated is that they could be too high for too long and that could spawn a recession,” he said.

“And finding that precise moment when inflation is moving toward the Fed’s target of 2%, but before the economy shifts into a recession, is spectacularly difficult.”

The Fed’s threading the needle here, Chang said.

“I think the Goldilocks zone between an inflation resurgence and recession risk is very narrow, which is why no one has ever truly succeeded in pulling off a soft landing,” he added.

There are, however, opportunities and silver linings as well as potential risks that commercial real estate investors should monitor, he said.

“It’s prudent to monitor for warning signs of a recession, but which ones?” he said.

One is the yield curve, which represents the difference between the short-term and long-term treasury rates.

The 2-year, 10-year yield curve inverted in July 2022 – that’s 22 months ago. But the 3-month treasury tends to be a bit more reliable, and the 3-month, 10-year yield curve inverted in October 2022 – 19 months ago.

“So, either a recession is right around the corner, or the inverted yield curve indicator isn’t working very well for some reason, Chang said.

“Maybe because of the economic disruptions created by COVID, or because of all the stimulus injected into the economy, or some other reason. But regardless, it looks like the inverted yield curve recession indicator, which has been blinking red for over a year and a half, might not be a good metric this time around.”

Chang also pointed to another indicator – the Sahm rule.

If anything, the Sahm rule has been even more accurate in identifying recessions than the yield curve, but it doesn’t give much of an advanced warning, he said.

The Sahm rule, developed by economist Claudia Sahm, says that if the average unemployment rate over the last three months is 50 basis points higher than the lowest three-month moving average unemployment rate over the prior 12 months, you’re probably in or will soon be in a recession.

Currently, the unemployment rate is 3.9%, and the three-month moving average is 3.87%.

And the lowest three-month moving average over the prior 12 months is 3.5%.

That difference is 37 basis points, which is below the 50-basis point threshold to signal a recession, which means, we’re probably not in a recession right now, and a recession likely isn’t imminent.

“But we’re getting pretty close to the edge,” he said.

If unemployment increases by 20 basis points to 4.1% in the next two months, then we might face an increased risk of a recession, Chang said.

Both Claudia Sahm and Moody’s Chief economist, Mark Zandi, have repeatedly said that the Fed should cut rates sooner rather than later and that the Fed is running the risk of breaking something, potentially causing a recession, by keeping rates too high for too long, according to Chang.

But remember, the Fed’s trying to do something that hasn’t been done, achieve a soft landing. And they’re being cautious.

Currently, the Fed is more afraid of a resurgence of inflation than they are of a recession, Chang said.

“If the Fed does spark a recession, hopefully it would be short and shallow, but you never know,” he said.

“And signs of a recession could probably be enough to spur the Fed to action, causing them to rip the Band-aid off and cut rates more aggressively.”

From a commercial real estate standpoint, Chang said a recession would affect investors firstly by potentially slowing household formation, weighing on demand for apartments and self storage.

Second, it could restrain consumer spending, weighing on demand for retail and industrial space.

Third, it could push interest rates down a bit, which would theoretically spur commercial real estate deal flow following a short market pause as investors recalibrate their underwriting to account for the recession.”

So, Chang will keep monitoring the unemployment rate.