Recent Recession Forecasts are Crying Wolf (4 min read)

It’s a sure way to attract media coverage: publish a report calling for recession in the next year. Analysts were doing it in 2016. And 2017. And 2018. And again now, as the US/China trade war escalates.

Obviously, they haven’t panned out yet. No surprise there, though, since most forecasts turn out to be wrong. The more interesting part is their underlying rationale.

Most recession forecasts fall back on a standard reading of business cycle indicators:

  • Unemployment is low and there is little slack in the economy so inflation will rise and the Fed will hike too aggressively.
  • The expansion is seven, eight, or nine years old and recessions become more likely the longer the cycle lasts.
  • The US won’t be able to withstand a global slowdown.

Typically, these kinds of forecasts aren’t worth the paper they’re printed on. The short of it is that none of those drivers has been the root cause of recessions for the past 30 years. And that isn’t likely to change now.

Leo Tolstoy wrote that ‘all happy families are alike but an unhappy family is unhappy after its own fashion.’ Well, one might characterize the boom and bust portions of the business cycle similarly. Boom times are generally good for the similar reasons, but recessions all have unique causes and miseries.

History of recessions

That said, looking back at the recessions of the post-WWII era the most recent three were qualitatively different from most of the ones spanning the late 1940s to the early 1980s.

Loosely speaking, the recessions up to the early 1980s were primarily business cycle recessions. Yes, there were other factors – the oil price spikes of the 1970s; and Paul Volcker’s interest rate policies in the early 1980s. But as the charts below illustrate, the heart of the matter was an economy that overheated, as evidenced by low unemployment and rising inflation. The Fed then cooled things off by raising rates until the economy tipped into recession. The Fed then cut rates, generating a sharp recovery in GDP and unemployment rate. These cycles mostly happened every few years.

On the other hand, the recessions of the early 1990s, 2001, and 2008-09 didn’t follow the business cycle template. The early 1990s recession was preceded by the thrift crisis of the late 1980s. The economy eventually fell into recession as markets tried to deal with the overhang of white-elephant commercial real estate and the cost of addressing it.

The initial recovery was slow and protracted, despite easy monetary policy. Unemployment continued to rise well after the recession ended and GDP rose only modestly compared to previous recoveries. Remember Bill Clinton’s mantra? – “It’s the economy, stupid!” And indeed the phrase ‘jobless recovery’ was coined during those lean years. The economy only got going again around 1995 once the thrift crisis overhang was worked off.

The 2001 recession was brought on by the dot-com collapse and exacerbated by 9/11. It was mild, but again, the initial stage of recovery was sluggish by post-war standards. Even though the recession ended in late 2001, unemployment lingered around 6% until late 2003 and GDP didn’t return to 4% until 2004 (see charts).

The 2008-09 recession arguably started as a business cycle recession, with an overheating economy being brought to heel with rising rates, although initially it was shallow and it took months before most people realized the economy was in recession. It wasn’t exactly a garden-variety post-war recession.

Then, the Lehman bankruptcy hit and the financial system plunged into crisis. That recovery process has been nothing like any other recession since the Depression. Unemployment didn’t start to fall until nearly one and a half years after the recession ended, and GDP growth has largely been stuck around the 2% level (see charts).

While acknowledging that the past three recessions have been quite different from each other, what sets them apart from previous recessions is the relatively long recovery between them, the key role of crisis in precipitating or exacerbating them, and the extraordinarily weak link between monetary policy and the recovery process.

Next recession

So what, if anything, does this tell us about the next recession? At the very least it probably won’t be a conventional business cycle recession. The Fed is far more likely to attempt to keep the recovery going rather than to drive rates to the point where recession is inevitable.

Rather, the next recession will most likely be precipitated by some exogenous shock or crisis. Rising interest rates or business cycle dynamics may contribute to the misery, but they won’t be the key driving force.

Trade probably won’t be that catalyst – at this point that is a “known-known”. More likely, is the prospect that trade tensions lead the Fed to over-ease, leaving it with nothing to fight whatever crisis does hit.

Barring a credible forecast of an emerging crisis the base case has to be that this recovery can go on in some form indefinitely. And as long as it does the risk asset trade will live on.

Chart 1: US GDP Growth

US gdp growth

Source: FRED

Chart 2: US Unemployment, Inflation and Interest Rates

unempl

Source: FRED

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role. He can be reached here.

 

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)

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