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Need to Know: This reliable indicator of recession has yet to waver

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As the Fed kicks off its two-day interest-rate setting meeting, the focus is on whether Jerome Powell & Co. stick to their hawkish tone or indicate the pace of rate hikes may slow down.

Certainly, there’s valid reason for at least slowing down, after another jumbo rate hike is delivered on Wednesday. Inflation at a headline level looks to have peaked, goods prices are starting to fall, the surge in commodity prices has unwound, and the housing market is deteriorating rapidly.

Keith Wade, chief economist and strategist at U.K. fund manager Schroders, says there’s one thing missing. “In many ways corporate behaviour has been puzzling this year as the consequence of slower growth and rising employment has been the weakest productivity growth on record,” he says.

But, outside of the tech sector, there just hasn’t been much talk of layoffs. “In our view firms have only been able to tolerate weak productivity and the subsequent surge in unit wage costs through being able to pass them on in higher prices. Otherwise margins would have been crushed as labor costs surged. Instead firms have been beneficiaries of high inflation. As a result, whilst household cash flows are under pressure, the corporate sector is yet to see the sort of squeeze which would trigger a retrenchment,” he said.

The flow of funds data from the Fed show this — that the corporate sector is running a financial surplus, where internal cash flow exceeds investment. “In previous cycles a deterioration in this balance and dip into deficit has been a reliable indicator of recession. This is the point at which companies begin to have funding problems as they have to tap into external sources to maintain current expenditure. Very often this results in a retrenchment as lenders and other capital providers seek reassurance that the business is viable,” he says.

Of course, if household finances keep deteriorating, then at some point consumers just won’t be able to tolerate higher prices. But not yet. The economic data is reinforced by the third quarter earnings season so far: “some downgrades, but no great calamities,” Wade says.

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