03 Nov Are we headed for a recession or not?
The U.S. economy expanded at a 2.0 per cent annual rate in the second quarter-a long way from a recession. Fed Chairman Jay Powell has just said that the central bank does not expect “at all” that a recession is imminent.
Yet forecasting markets are a little more misleading, putting the odds of a recession around 40% in President Trump’s first term. And then there’s the notorious “yield curve inversion”–the confluence of bond market moves that has persuaded many that the recession is coming in the next few years.
The truth is that we just don’t know. Forecasting recessions is one of the least accurate tasks we carry out in economics, nestled right behind the prediction of short-term stock market movements. If we’re honest, the best we can do is point to encouraging or worrying indicators and take our best guess as to how they balance each other. That said, here’s what the landscape looks like and what it might mean.
Defining a recession Before we get into all that, what do we mean by a recession? We don’t even have a full agreement on that. In popular terms, the recession is two consecutive quarters of negative GDP growth. Nevertheless, in the United States, the National Bureau of Economic Research (NBER) marks the start and end of business cycles (recessions and periods of growth). It provides a different definition: “Recession is a significant decline in economic activity distributed across the economy, lasting more than a few months, usually noticeable in real GDP, real income, jobs, industrial production, and wholesale retail sales.” Hence, a broad and enduring recession which we generally associate with a sense of malaise. According to the NBER, the last downturn–one of our worst–began in December 2007 and ended in June 2009. This means that the resulting extension lasted more than ten years –longer than the longest stretch we’ve had in the United States (which was March 1991 to March 2001).
It leads to another question: what triggers a recession? It’s the topic of a hot debate. One view is that there are business cycles which operate with some predictability. To explain this storey: consumers run up over-indebtedness and need to reduce their spending; lower consumer spending means that companies invest and employ less; consumers cut their spending further when they lose jobs. Instead, at some point, old cars and appliances need to be replaced and people with children move from small apartments to start-up homes; customers go out and buy; businesses hire and invest to meet these consumer demands; wages rise and jobs proliferate. So, the cycle is going down and up.
Another argument, in the words of former Fed Chair Janet Yellen, is that expansions do not die of old age. In this view, expansion can continue indefinitely, if properly managed. Recessions occur when policy mistakes are made by those managing the economy. That could be interest rates that are too high and that choke off economic growth. Or it could be a wrong economic, regulatory perhaps trade strategy.
Predicting a recession Despite this fundamental disagreement as to what causes a recession, it’s not hard to see the challenge in predicting when the next one happens. Even so, there are some indicators that have traditionally been very good at predicting downturns. Perhaps the most important of these is the “inverted yield curve.” The curve in question traces the interest rates of the United States. The Treasury has to pay to borrow money. In general, if an investor sees good economic times and growth ahead, he or she will want to be compensated for having his or her money tied up in a Treasury bond. The longer the money is tied up, the lower the level of demand.
As a result, a 10-year bond is expected to have a higher interest rate than a 2-year bond. And most of the time, that’s true.
But, every now and then, the 10-year Treasury interest rate dips below the 2-year interest rate. This is the condition that people refer to as an “inverted yield curve.” It happens when the line falls below zero in the index. The remarkable thing about the map, which traces the U.S. experience back to 1976, is that the curve inverts before those vertical grey bars, and only before those vertical grey bars. And the vertical grey bars are recessions.
Why would it be? In order for the return on a 10-year bond to be lower than that on a 2-year bond, the investor must anticipate falling returns on investment. That’s the kind of thing you expect to see when the downturn is coming. So there’s a plausible explanation why the predictor is supposed to work so well. And we’re talking about this now, because the yield curve just flipped at the end of last month.
Of note, this is not the only way to predict a recession. The popular approach is to look at the different components of GDP, such as business investment, trade and consumer spending, and to see how each component is going. Recently, stronger consumer spending has more than offset weaker trends in business investment and trade. Prognosticators became more concerned in August, when consumer sentiment weakened late in the summer.
No one can say for sure, but…
Finally, one might wonder how difficult a challenge it will be for policymakers to stabilise the economy. Ideally, those policymakers would like to enter a perilous period with high central bank interest rates (a lot of room to cut), low federal deficits or surpluses (room to spend), a booming global economy (more demand for US exports) and a calming, growth-promoting trade policy.
That’s the opposite of what we’ve got in every dimension now. Interest rates are low, deficits are high, other major economies are slowing or weakening, and trade policy risks are expected to reduce US development.
There is no way to say whether the recession is fast approaching. But there are plenty of reasons for concern.