The odds of the economy falling into recession are climbing, as the Federal Reserve boosts interest rates sharply to rein in inflation that is lingering at a decadeshigh rate. As a result, consumer sentiment has plunged and threatens to derail consumer spending that supports roughly two-thirds of the economy.

Pandemic-related shortages of material and labor and persistent snags in supply chains have caused prices to vault higher for months. Inflation as measured by the consumer price index (CPI) rose by 9.1% over the year in June, its fastest pace in over four decades. The rise in the index slowed to 8.5% in July and to 8.3% in August, mostly due to the falling price of gasoline, suggesting that peak inflation was reached in June. However, core CPI, which excludes food and energy prices, unexpectedly accelerated in August, with broad-based gains across many products and services.

In response to rising prices, the Federal Reserve is engaging in an aggressive tightening program, having already raised its policy rate by 225 basis points since March, including unusually large increases of 75 basis points at both its June and July FOMC meetings. The central bank is also shrinking its bloated balance sheet. Beginning in September, almost $100 billion of assets will be allowed to mature without reinvestment, shrinking the monetary base. Federal Reserve Chairman Jerome Powell has repeatedly stressed that the committee is focused on its price stability mandate and will push rates higher until inflation is brought down, even at the risk of triggering job losses and an economic slowdown.

Rising prices and recession fears have weighed heavily on consumer sentiment and are evidently leading to demand destruction. Consumer spending was supported by stimulus payments that were sent to households during the pandemic but has been slowing since the beginning of the year. The anticipated rotation in spending away from durable goods such as automobiles and furniture to services such as restaurant meals and hotel stays has been slower than expected. Real spending on durable goods rose by 1.5% in July, led by spending on recreational goods and vehicles, while spending on nondurable goods fell by 0.5%. Meanwhile, spending on services rose by a mere 0.2%, a notable slowdown from earlier in the year.

Economic momentum had already flagged in the first half of 2022, which saw two quarters of negative economic growth, often seen as the definition of a recession. With demand continuing to cool, most analysts have downgraded their overall annual growth estimates.

But the labor market is still tight. An average of 562,000 jobs were added every month in 2021, and more than 3.5 million more have been added so far in 2022. The unemployment rate in August was 3.7%, ticking slightly higher than the previous five consecutive months when the unemployment rate was close to its pre-pandemic level. Labor participation also inched higher but is still below pre-pandemic levels as workers continue to cite COVID fears and a lack of childcare options as reasons to remain on the sidelines.

With 11.2 million job openings recorded on the last day of July, near a record high and representing almost two job vacancies for each unemployed worker, competition for workers is driving wages higher, but inflation is eroding household incomes. Personal income grew by just 0.2% in July, the slowest rate since January, and the personal savings rate held at 5% for the second consecutive month, its lowest rate since August 2009, as households dipped into savings accounts to support their spending.

Other recent data confirm a slowdown in activity. News of hiring freezes and impending layoffs are widespread, suggesting that the labor market will slow in coming days. Business investment is at risk as factories report new orders for their products are slowing. And with mortgage rates rising to levels not seen in years and housing prices still uncomfortably high, affordability has eroded, leading to a sharp turnaround in what had been a red-hot housing market. Sales of both new and existing homes have fallen in recent months as potential homebuyers are being priced out of the market.