Here we go again
There’s a renewed danger of recession this year, and to explain why it’s worth revisiting the recent past. I have argued that we normally would have had a recession last year, but a nimble Fed was able to adjust policy in time to prevent the recession and create America’s first expansion of more than a decade.
On many occasions, Fed policymakers make contractionary errors late in a business cycle. The yield curve inversion such as occurred in March 2019 is normally a pretty good recession forecaster, but not perfect. It depends on how the Fed reacts. But just being far enough along in the business cycle that unemployment has fallen to the natural rate is likely as good a recession forecaster as the yield curve inversion, indeed they often go together.
The Fed avoided recession in 2019 because it ignored its Keynesian Phillips curve models that suggested overheating, and reduced rates three times. The Fed was looking at market indicators, not the unemployment rate. (Hmmm, who’s been suggesting the Fed be guided by market indicators?)
In early 2019, the trade war with China disrupted manufacturing and reduced the equilibrium (or “natural) interest rate. Fortunately, the Fed saw what was happening and responded. Now, in early 2020 the coronavirus is disrupting Chinese manufacturing and reducing the equilibrium interest rates. The yield curve has once again inverted (3m/10y). Let’s hope that the Fed sees what’s happening and once again responds aggressively. If so, there will be no recession. (Or we might luck out and the coronavirus fades away quickly.)
The consensus of economic forecasters (at the Philly Fed) calls for roughly 4.0% NGDP growth from 2020 Q1 to 2021 Q1. That’s 2.1% RGDP growth and roughly 1.9% inflation (using the PCE, not the deflator) The Hypermind prediction markets says 2.95%, which is quite a discrepancy.
The Philly survey of private economists has been consistently too optimistic on inflation for a decade, just like the Fed itself. But the discrepancy is presumably also due to a lower RGDP forecast at Hypermind. When I first noticed the discrepancy a few months back, I indicated that I was about halfway in between the two in my forecast. I’ll stick with that. Say 3.4% (1.7%/1.7%).
On balance, I don’t think there’ll be a recession this year. But if the Fed ignores market warnings that the equilibrium interest rate is falling, then a recession becomes much more likely. Let’s hope they pay attention. They’ve done such a nice job under Powell that it’d be a shame to see all those gains washed away.
Or as a Hollywood tough guy would say, “Nice expansion you got there Jay, it’d be a shame if something happened to it. How about 50 basis points?”
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21. February 2020 at 12:32
Yes, I agree and we need an institutional makeover. While at least Powell leans slightly the right way on market indicators, the Fed always seems to be more afraid of lowering rates to early than to be raising rates too early—it seems to be an institutional bias as if it were improper or unseemly—-or even irreligious. I think it is also very hard not for them to not look at the Phillips Curve–the Talisman they won’t bury.
They were late to the dance in 2018 and they seem on the path to being late again this year. The Virus may (or not) be overstated as a deadly disease—but it is surely not overstated as a potential drag on economic activity.
I also think they are afraid—i.e., extremely overcautious, about being symmetrical around their inflation target. They just refuse to do it. And it also does not help that most market commentators already believe the Fed has a “loose money” bias. To quote an Attorney General you know —-it is must be hard for Powell to do his job when the market hounds him one way while the President hounds him another.
Why is it so hard to have a consensus around the right monetary approach? What is it about “money” that makes smart people dumb?
21. February 2020 at 12:40
(not suggesting I am not one of the dumb ones–:-))
21. February 2020 at 12:46
Powell lagged the markets in 2019 and appears to be determined to do so again.
So many ways to think about this. Here’s one: when the market price of 10-year US government debt carries a yield of 1.46%, why on Earth would the Fed borrow money from banks at an IOER rate of 1.6%?
21. February 2020 at 13:16
What if coronavirus panic takes hold in the US and large parts of the US economy are shuttered for long periods of time? What if that happens all over the world? I don’t think that there is any amount or kind of monetary policy that could prevent such a scenario from causing a recession.
It seems that most experts are pessimistic that the new virus can be contained at this point in time. Developments in Iran and South Korea certainly aren’t promising.
21. February 2020 at 13:58
I’d say we are at risk of recession so long as the Fed continues to allow and to be seen as allowing the PL to stay below where it would be if they really had an average inflation target.
Why is mis-making policy according to a “Phillips Curve” KEYNESIAN? Keynes called for tighter fiscal policies when near full employment. Where in the General Theory does it say that monetary policy has to be tightened BEFORE inflation is a problem?
21. February 2020 at 17:19
The 30-year Treasuries are offering all-time record low yields. The 10-year Treasuries offer 1.47%.
Also unsettling is the fact that orthodox macroeconomist have never called a recession. And, in general, macroeconomists have spent the last 40 years predicting higher rates of inflation and interest rates when instead interest rates and inflation have fallen.
The Fed should lower interest rates and continue with quantitative easing. I would prefer a formal money-financed fiscal program approach, that is tax cuts on wages, but that appears out of the cards.
Gee, why would anybody suggest cutting taxes on wages to stimulate the economy? Only an economist wearing a tin-foil hat!
21. February 2020 at 18:33
Benjamin, cutting taxes on wages might still be good supply side policy.
22. February 2020 at 03:11
The 30 year Treasury yield didn’t come close to recovering from its steep drop during the tariff tantrums. The recovery was very mild. Why is that?
In part, economic growth expectations still haven’t rebounded since the trade wars eased a bit. But also
, I suspect the zero lower bound is to blame. More specifically, the Fed’s expected approach to policy at the ZLB is still a drag on growth, just as it’s been for most of this century thus far.
The Fed’s approach to QE without even the determination to consistently achieve it’s inflation target is the problem. Inflation targeting is bad enough without the ZLB.
22. February 2020 at 07:39
Matthias Görgens:
Yes, cutting taxes on wages is good supply-side economics, and, of course, in general we should never tax productive behavior, whether investing or working.
But…cutting (in the US) FICA payroll taxes would also be an excellent counter-cyclical or anti-recessionary policy. No dubious federal spending programs.
The tax cut could be financed through the Fed buying US Treasuries and placing them into the Social Security fund, to offset lost tax receipts.
This plan would be a version of QE that actually stimulates demand, and not merely inflates global asset values (the present version).
Moreover, my plan would stimulate demand inside US borders, which is what a national government is supposed to do (when needed to fight recession).
My plan would avoid adding to the national debt.
Would my plan be inflationary? Probably not. The experience of Swiss National Bank and the Bank of Japan suggest QE is not inflationary, even in large dollops. Very large dollops.
22. February 2020 at 13:57
@ B Cole
Since the Fed is part of the nation I don’t see why a reduction in the FICA plus it’s gift to the SS Trust Funds would avoid dding to the national debt or why one would want to avoid it during a recession. Which is not to say that eliminating the FICA during recessions (and replacing it with a VAT during non-recessions) is not a good idea.
@ M Rulle
Well said. I’ll believe that the Fed has a symmetric inflation target when I see it taking steps to move the price level back to some previously established target trajectory and then fluctuate around it. But the big question is why?
22. February 2020 at 14:50
Sumner in quotes (kind of like Alice in Chains but different):
SS: “I have argued that we normally would have had a recession last year, but a nimble Fed was able to adjust policy in time to prevent the recession and create America’s first expansion of more than a decade”- translation, ‘I, Scott Sumner, was wrong’. It’s OK, as a wise man (not a wiseman either) said: “It’s hard to make predictions, especially about the future.”- Y. Berra
SS: “The Fed avoided recession in 2019 because it ignored its Keynesian Phillips curve models that suggested overheating, and reduced rates three times” – I’m sure the Keynesians would disagree, especially since they themselves have said the Philipps curve died about, oh, 30 to 40 years ago. Do try and keep up with the literature.
SS: “The consensus of economic forecasters (at the Philly Fed) calls for roughly 4.0%”, then “The Hypermind prediction markets says 2.95%” and finally, “I indicated that I was about halfway in between the two in my forecast. I’ll stick with that. Say 3.4% (1.7%/1.7%)”. Oh, bold! Scott splits the difference, a Solomonic decision…
SS: “On balance, I don’t think there’ll be a recession this year. But if the Fed ignores market warnings that the equilibrium interest rate is falling, then a recession becomes much more likely. ” – I see what you did there professor. That’s known as “hedging your bet” and is considered bad form in gambling. “Heads I win, but, if it’s not heads, I’m calling tails, so tails you lose”. No, you can’t have your cake and Edith too. Which is it? By definition, using Sumner’s tautology, if no recession then the Fed ‘got it right’ but if a recession the Fed ‘ignored’ the market warnings? I’d like SS to please inform us what ‘market warnings’ there were before each of the many recessions we’ve had to date. I’m sure he can cherry pick a different indicator from a plethora of indicators, but I’d like to see his list. Please professor?
“Nothing succeeds so well as success”- Charles Maurice de Talleyrand (a two-faced cynic, note the tautology and draw the analogy)
22. February 2020 at 16:53
Thaomas: under my plan there would be no increase in the national debt.
Okay, let us imagine there is a triggering event such as real GDP slowing or unemployment rising above 3.8%.
1. The Social Security Administration declares a tax holiday.
Employers and employees get an immediate tax break,
2. The Federal Reserve begins to buy Treasury bonds, which are placed into the Social Security trust fund. As there are about $20 trillion in such bonds outstanding, there is no shortage. The federal government does not have to issue new Treasuries and run up debt. Additionally, the Federal Reserve could buy sovereign bonds of other nations and place those into the Social Security fund.
So, would this action by the Federal Reserve in buying and placing bonds into the Social Security trust fund trigger inflation?
In recent years, to stabilize the exchange rate of the Swiss franc, the Swiss National Bank bought about $100,000 in sovereign bonds of other nations, per resident of Switzerland, and yet did not trigger any inflation.
The Bank of Japan has purchased sovereign bonds equal to about 100% of Japan’s GDP, and they are slipping back into deflation.
There is a reason such thinkers as Stanley Fisher or Adair Turner are proposing money financed fiscal programs. In macroeconomics, no one is ever wrong, but I think these two gentlemen may be right.
22. February 2020 at 17:53
Lest I be accused of trolling, it turns out Sumner was right on his “Phillips curve” point and I was wrong. Indeed, the Fed still relies on the validity of a classic Phillips curve, incredibly. Cite below*.
*The Phillips Curve: A Poor Guide for Monetary Policy (Cato, Feb. 2020) by J.A. Dorn – quotes: “[The] persistent shortfall in inflation from our target has led some to question the traditional relationship between inflation and the unemployment rate, also known as the Phillips curve. . . . My view is that the data continue to show a relationship between the overall state of the labor market and the change in inflation over time. That connection has weakened over the past couple of decades, but it still persists, and I believe it continues to be meaningful for monetary policy. —Fed Chairman Jerome Powell (2018: 6–7)
23. February 2020 at 09:18
Ray, You said:
“translation, ‘I, Scott Sumner, was wrong’.”
You do know that I went against the inverted yield curve people and predicted no recession last year, don’t you?
I guess not.
So will you now praise me for being correct about no recession in 2019? If not, I might ban you.
23. February 2020 at 16:33
@ssumner – ok, I concede you may have went against the inverted yield curve people and predicted no recession last year (anyway the yield curve inverted and then un-inverted several times)
My notes indicate however that it’s not safe to say the inverted yield people were wrong until Dec 2020 at the latest. That’s because of this fact: “Recession sometimes takes 1 year to 2 years to start after yield inversion” and the first inverted yield signal was December 2018. So we’re not out of the woods yet. And if Covid-19 causes a recession, you can say the ‘inverted yield people were right’ –just by luck, since they obviously could not foresee a macro shock caused by a randomly occurring pandemic.
Don’t ban me please, I have fun flaming you.