When’s the next recession coming?
It’s a fair question, especially in year 10 of this record expansion, but I’ll confess from the outset that it’s one nobody can answer with confidence.
And yet, with various economic head winds gathering, both here and more so abroad, it’s a good time to collect what we know about economic downturns — and what we don’t. There’s a lot more of the latter, especially when it comes to predicting recessions.
Think of it this way. You’re driving along a highway and your passengers want to know if and when you’re going to break down or crash. You can look at the gauges, the weather and the road conditions and make a reasonably accurate near-term prediction. If there’s gas in the tank, the engine’s not overheating and traffic’s moving along, you can confidently predict that we’re good for the next few miles. Beyond that, though, who’s to say that another driver won’t swerve into your lane or that you won’t blow a tire?
With that in mind, here are some reasons to stay calm — followed by some reasons not to.
The mighty American consumer. A recession means falling gross domestic product, and U.S. GDP is 68 percent consumer spending, so if the average American consumer is doing well, GDP is not likely to fall, at least in the near term (say, four to six months). This first chart shows the strong linkage between earnings and consumer spending, with both adjusted for inflation (the shaded areas are recessions). As you’d expect, the two variables track each other closely. Most recently, both are holding up well: Job gains average about 170,000 per month, and real weekly earnings for middle-wage workers are up about 1.5 percent over the first half of this year.
Even now, a decade into an expansion with unemployment near 50-year lows, there are people and places left behind. For many of those communities, recession is the norm. But here, we’re talking about the overall economy.
On the other hand (these recession discussions invariably invoke many hands), the figure shows that this relationship can quickly go south: The earnings-spending connection is more of a coincident than a leading indicator.
Private balance sheets are in decent shape. Historically, recessions stem from three broad causes: overheating, supply shocks and sectoral bubbles. Overheating in this context means ever-rising inflation such that the Federal Reserve must slam the brakes (by jamming up interest rates) to break the cycle — that’s what happened in the early 1980s downturn. A supply shock is when a vital input, like oil, suddenly becomes scarce, as in the mid-1970s oil shock.
These causes appear to have become less prevalent. The Fed has waged a decades-long campaign to tightly control inflation, and globalization has led to much more robust supply chains (which also dampen inflationary pressures).
That leaves the last problem, sectoral imbalances. The last two recessions, the mild one in 2001 and the deep one in 2008, were born of dot-com and housing bubbles, respectively. When an economically large bubble bursts, usually because too much credit has been doled out to non-creditworthy sources, a bunch of wealth goes up in smoke. People, banks and companies reel in their spending, lending and investments until their balance sheets recover.
There’s been some concern about such imbalances in the current context, but the data, at least for now, are somewhat reassuring. Economist Jan Hatzius elevates a useful indicator that gives a look at the condition of the balance sheets of households and businesses. Shown below (as a share of GDP), it’s a measure of income minus spending (or savings minus investment), called the private-sector financial balance.
Note that before 2000, the balance may have flitted about, but it stayed reliably in the black. Since then, however, it has fallen well below zero, signifying a level of indebtedness that turned recessionary when a lot of shaky bets went bad, before climbing back up again. Right now, it’s in a pretty good place. By the way, that’s not because firms or households are not carrying debt. It’s because (a) they’re also making money and (b) the cost of servicing that debt — the interest rate — remains low.
So that all looks pretty good, but there are some indicators pointing in a less favorable direction.
The inverted yield curve. Since investors want to be compensated for tying up their money for many years, long-term interest rates tend to be higher than short-term ones. However, in rare times when investors expect slow growth, low interest rates and low inflation, long-term rates can fall below short-term rates, in a phenomenon called a “yield curve inversion.” What matters for our purposes is that this interest-rate flip has regularly been followed, typically in the next 12 to 24 months, by downturns.
By some measures, this is one of those times when the yield curve is inverted. Given the track record of that indicator, that’s a strong argument that a recession is on the way, though as I just noted, it can be a while between inversion and recession.
High public debt. While private balance sheets look okay, the federal government’s ledger is way in the red. Public debt is closing in on 80 percent of GDP, awfully high for this stage of recovery. In fact, since 1950, the average debt/GDP ratio with unemployment around its current range has been about half of today’s level.
There’s no evidence yet that this debt is an economic head wind, either in the overheating or debt-bubble sense. But it’s still problematic. Once we hit a downturn, for whatever reason, we’re going to need the federal government to quickly implement deficit-financed, countercyclical fiscal policy, like extended unemployment insurance and help for strapped states. History shows that governments are less likely to deliver such relief when they enter the recession with high debt levels.
In other words, high public debt may not trigger a recession, but it could easily make one worse.
Trade war: The Trump administration’s tariffs and retaliation by targeted countries have contributed to a significant slide in global trading volumes. Because our import and export shares of GDP are lower than those of our trading partners, the U.S. economy is less exposed to the disruption of supply chains, though people in some sectors, such as farmers, have taken direct hits. But trade disruptions are hurting global growth, and both through export and financial channels, that could easily become a contributing factor to a downturn.
So what should we expect in the future? Using a simple model to assess the probability of a downturn a year from now, if I look just at the yield curve, that likelihood is an unsettlingly high 32 percent. However, if I plug the data about consumer spending and private balance sheets into the model, that falls to a negligible 3 percent chance of recession by mid-2020.
At this point, like President Harry Truman, you can be forgiven for seeking a one-handed economist. I can tell you with moderate confidence that, barring unforeseen shocks, the near future looks recession-free. Beyond that, I guarantee you there’s a downturn out there somewhere. So our best play would be to get ready for it while the sun’s behind just a few clouds.