U.S. Recession No Longer Improbable: No Longer Fresh at Project Syndicate

The World Economy Goes Hollywood by Anatole Kaletsky Project Syndicate

Project Syndicate: U.S. Recession No Longer Improbable: Over the past 40 years, the U.S. economy has spent six years in four recessions: in a downturn 15% of the time, with the odds that a current expansion will turn into a downturn within a year being one-in-eight. Of these four downturns, one—the extended downturn of 1979-82—had a conventional cause: the Federal Reserve thought inflation was too high, and so hit the economy on the head with the high interest-rate brick to stun it and induce workers to moderate their demands for wage increases and firms to cut back planned price increases. The other three have been caused by derangements in financial markets: the collapse of sunbelt Savings-and-Loans for 1991-92, the collapse of dot-com valuations in 2000-2, and the collapse of mortgage-backed securities in 2008-9.

Right now, inflation expectations appear to be well-anchored at 2%/year, with a Phillips Curve that seems unusually flat—excesses or deficiencies of production and employment from potential-output or natural-rate trends have little short-run impact on prices and wages. Right now both the gap between short-term and long-term safe interest rates and the level of short-term nominal safe interest rates are unusually low. And right now, with the recent decline in the stock market, Campbell-Shiller-like forecasts of long-run real buy-and-hold stock returns are between 4% and 4% per year—higher than their average CS-like forecast value over the past forty years.

Those are the background facts that everybody in the business of forecasting the arrival of and hedging against the possibility of the next U.S. recession must have in the front of their mind. They have several implications:

  1. The next recession is unlikely to come as a response to an uptick in inflation that triggers a Federal Reserve shift from trend-growth-nurturing to inflation-fighting policy. Something else that triggers a downturn is highly likely to occur as visible inflationary pressures are unlikely to build in less than half a decade.

  2. The next recession is likely to come as a result of the revelation of an unexpected weakness and an unexpected shock to financial markets that causes a sudden, sharp "flight to safety". That is one pattern that has been generating downturns since at least 1825 and the collapse of that decade's canal boom in England. That is most likely to be the active pattern now.

  3. The financial shock will be unanticipated. Investors, speculators, and institutions are generally hedged against possible shocks that are seen by the conventional wisdom as live possibilities. It was not the collapse of the mid-2000s housing bubble but the concentration of ownership of mortgage-backed securities that killed the global economy in 2008-9. It was not the deflation of the commercial real estate bubble of the late-1990s but the failures of regulatory oversight that had lead S&Ls to gamble for resurrection that triggered the stubbornly long downturn of the early 1990s. it was not the deflation of the dot-com bubble but the magnitude of tech-and-communications earnings "overstatements" in the late 1990s that triggered the early 2000s recession.

  4. The near-inverted yield curve, the low absolute value of nominal and real bond yields, and equity values that are now plausibly fairly-valued for the long-term tell us that financial markets in the U.S. are now pricing a recession as likely—and, to the extent that business investment committees are thinking like investors and speculators, it requires only a trigger for businesses to retrench investment spending and so bring a recession on.

  5. If that recession begins, the U.S. government will not have the tools to fight it: the president and congress will, once again, as they have for a generation, be inept at using fiscal policy as a countercyclical stabilizer; the Federal Reserve does not have enough room to cut interest rates to do the job; and the Federal Reserve lacks the nerve and perhaps lacks the power for truly effective non-standard monetary policy moves.

For the first time in nine years, Americans and investors in America need to be prepared for not a probable but rather a not improbable economic downturn—and for the likelihood that should such a downturn come, it will be a deep and prolonged one.

#projectsyndicate #monetarypolicy #recessionwarning #highlighted

Forty Years of the Yield Curve

Cf.: Carmen Reinhart: The Biggest Emerging Market Debt Problem Is in America: "A decade after the subprime bubble burst, a new one seems to be taking its place in the market for corporate collateralized loan obligations. A world economy geared toward increasing the supply of financial assets has hooked market participants and policymakers alike into a global game of Whac-A-Mole...

The U S Stock Market Nominal