Recessions in a post-inflation world
The Financial Times has an article pointing out that inverted yield curves are not a foolproof predictor of recessions, a point I’ve frequently made. (It’s actually a pretty good forecasting tool, just not perfect.)
In the article, Gillian Tett cites BIS research:
But as this inversion-watching game intensifies, it is worth reading a recent paper from the Bank for International Settlements, the central banks’ bank in Basel. It suggests that term spreads — what the shape of the yield curve measures — are not as good at predicting downturns as widely assumed and that there are other, better indices that economists and central bankers could (and should) use.
The authors start from the belief that the nature of business cycles has subtly shifted recently. In decades past, downturns were often sparked by rising inflation. But today, consumer price inflation seems increasingly benign, if not downright boring. They write that “there has been a shift from inflation-induced to financial cycle-induced recessions”. For this argument, the BIS staff define financial cycle as “the self-reinforcing interactions between perceptions of value and risk, risk-taking, and financing constraints”. The 2008 financial crisis is a case in point: a boom-to-bust financial cycle sparked a recession.
Obviously I don’t agree with that. But there is a real change in the nature of recessions now that inflation is no longer a major problem.
In the past, some recessions were at least partly intentional. When inflation rose to unacceptable levels, the Fed tightened monetary policy to slow NGDP growth. A recession occurred. Even in 2008, inflation played a role, as the Fed was reluctant to cut rates during the late spring and summer months because of inflation fears.
Nonetheless, I do believe that financial cycles now play a bigger relative role, but not in the way the BIS assumes. (Recall that this institution was consistently wrong about monetary policy during the decade after 2007.)
Financial cycles do not directly cause recessions, but they may indirectly do so if they lead interest rate-targeting central bankers astray. When a financial cycle enters a downturn, the natural rate of interest falls sharply. If the central bank doesn’t respond in a timely fashion (by keeping its eye of forward looking market indicators), then money will get too tight and a recession will occur.
If the central bankers of the 1950s were in charge of the Fed during 2019 then we would now be in recession. Because they did not place enough weight on market indicators, we had 4 recessions between 1949 and 1960. We also had 4 recessions between 1970 and 1982. That’s way too many.
In another post I pointed out that central bankers following Phillips curve-type Keynesian models would have pushed the US into recession in 2019, as the very low unemployment rate suggests (in those models) that the economy was in danger of overheating.
Instead, the Fed looked at market indicators and did an abrupt shift from raising rates to lowering rates. There was no recession in 2019, and most forecasts now call for no recession in 2020. The longest expansion in US history is likely to go on for at least a few more years.
Because most developed countries have inflation under control, recessions caused by tight money aimed at restraining inflation will become very infrequent. By itself, this suggests that we will have fewer recessions than in the past. If the Fed continues to pay increasing attention to market signals, we will also have fewer recessions caused by the Fed not responding quickly enough to financial cycle-induced changes in the natural rate of interest.
I was taught that the average business cycle in the US lasts about 4 years. If I’m right (and I am pretty sure that I am right), then in the 21st century the average business cycle will last much more than 4 years, at least 15 to 20 years. Unfortunately, I won’t live long enough to know whether I am right.
PS. This made me laugh:
Four months ago, the yield on long-term US Treasury bonds fell below that for short-term ones, creating what is known as an “inverted yield curve”.
This sparked jitters, given that yield curve inversions preceded “seven of the last seven recessions”, with a lag of “8-60 months”, according to a recent Bank of America Merrill Lynch client note.
60 months? Why not 120 months, then the prediction would be even more reliable.
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14. November 2019 at 16:17
An interesting proposition, based on Japan and somewhat Europe: Nations that have flat or declining populations will also have little or no inflation, and possibly deflation. I have no theory to explain this.
If this is true, it opens up a whole new vista for monetary and fiscal policies.
By the way, there are two cities where rents are very high in relation to income. One is Hong Kong and the other is Santiago Chile.
14. November 2019 at 18:44
That’s incredible; I wonder what else the inverted yield curve predicted with a lag of 8-60 months? Let’s see… elections of a Democrat, elections of a Republican, Non-recessions, wars… what can’t it do!
14. November 2019 at 19:04
Well, true about 60-month lags.
But then, one of the most serious of macroeconomic thinkers said monetary policy would have results “with long and variable lags.”
You could hide a pachyderm under a tent like that.
14. November 2019 at 20:11
Gillian Tett wrote: “a boom-to-bust financial cycle sparked a recession” and Chairman Powell uses the term “mid-cycle”.
Both persons and much of the financial press are okay with this but I’m not. A boom to bust interval is the part of the cycle that complements the bust to boom. Neither is a cycle. Together they can be. There is no point in time that is particularly apt be described as mid-cycle because all points in time are part of the cycle. Mid-expansion and mid-contraction make more sense.
15. November 2019 at 00:17
It’s simple to understand why inverted yield curves don’t always predict recessions. The Fed looks at them too, and has a somewhat modest (ahem) role in determining the slope. If it was a competition, you’d call it cheating. A better analogy might be a lazy, distracts, not very good driver, occasionally checking the speedometer.
15. November 2019 at 02:14
Scott, look on the bright side, at least you will live long enough to know if you are wrong.
15. November 2019 at 05:52
Is Sumner using the term “financial cycle” to distinguish it from “business cycle”, or is he using the two inter-changeably? https://voxeu.org/article/understanding-financial-cycles-0
15. November 2019 at 06:08
Great post. The improvement in central bank performance is a great rebuttal to the increasingly frequent articles on how macro economics is broken / isn’t a real science / can’t predict recessions.
15. November 2019 at 07:13
An inverted yield curve is information. When the Fed responds to an inverted yield curve, a recession can be avoided. That’s what happened this year, with the Fed reluctantly and belatedly cutting rates a step behind the market.
The Fed caught up with markets in October, but then Powell has to open his yap about “no December cut”. Dammit Jay, just stick with “data dependent”. All you are doing is reinforcing the impression that the Fed is biased in its inflation targeting.
CPI up 2.4% in past 10 months, but PCE up just 1.0%. Why does Fed say it’s targeting 2% PCE when it clearly isn’t?
If the yield curve inverts while inflation is running hot, that’s a problem. But the 2019 inversion was easily manageable. As of right now, the yield curve is flattish at teh short end but increasing at longer terms, but every time Powell says something, it gets a little flatter.
15. November 2019 at 07:15
I mean, we now have 8 years of compound PCE growth below 1.4%. Big and consistent and accumulating misses. Not one year where PCE was up 2% in the span. From an AIT or NGDP perspective, it’s a pretty big miss.
15. November 2019 at 07:47
Yes, the 8 months to the 5-year lagging indicator is pretty funny—-it reminds me of the idea of “predicting 10 out of the last 3 recessions”—-except this time they do get a higher “hit rate”! Your 15-20 year “forecast” for average length of business cycles is quite optimistic–especially your “pretty sure you are right” add on.
It does seem odd, however, that almost “suddenly” central banks are following market forecasts of their own policies. There seems to be the bugaboo I always see—-circular reasoning. Markets have, presumably, always tried to forecast what the Fed will do—-not forecast what they want the Fed to do.
Your assistance in getting me out of the tangled web I weave will be appreciated.
15. November 2019 at 11:03
Nick, That’s the dark side. 🙂
Rayward, I am distinguishing between the two. The stock market crashed in 1987, but there was no recession.
Michael, The key is CONDITIONAL market forecasts. The fact that markets expected lower rates this year is, by itself, meaningless. The fact that the markets expected both rate cuts AND sub-2% inflation is extremely important.
You want the market forecast of the policy setting that leads to 2% inflation.
15. November 2019 at 11:30
“The fact that the markets expected both rate cuts AND sub-2% inflation is extremely important.”
Excellent.
16. November 2019 at 06:06
Michael, if we had deep and liquid markets for those conditionals (ie derivatives) this would be easier to see.
Compare also https://en.wikipedia.org/wiki/Futarchy
17. November 2019 at 12:46
I like looking at total nominal aggregate wages (hourly wage * hours per week * number of employees). Since 2010, it’s grown at 4.5% annually.
https://fred.stlouisfed.org/graph/?g=mKZj
In terms of nominal conditions, the current expansion is remarkable. It’s nominally slower than all other expansions of the past 55 years. It’s also much, much, more stable.