In May 2022 I estimated a 35% chance of a recession, when many commentators were saying that a recession was inevitably imminent.
Until quite recently I was becoming slightly more optimistic that the US would achieve a soft landing.
Last week, I became concerned enough to raise my estimate of a near-term recession to 50%. My current guess is 2 to 4 quarters of near-zero GDP growth.
I’m focusing on these concerns:
- Are wages too high?
- Are monetary conditions tightening?
- How Far is Inflation from the Fed’s Target?
- What to the most up-to-date indicators say?
Wages
Most of the harm associated with recessions stems from companies laying off employees. That happens when there’s a decline in the wages at which supply and demand for labor are in balance, and cutting wages (or expected raises) would leave employees unhappy enough to hurt their productivity.
Normally wages are close enough to that threshold for a modest amount of deflation to trigger excess layoffs.
Recent conditions are unusual in that the sudden, transitory burst of inflation in 2021 created a need for unusual wages increases. We’ve been having labor shortages since then because wages are slow to respond. That likely means that a small amount of deflation would bring labor markets back into normal balance.
The last time the US had conditions like that was in the 1940s, due to the unusual WWII inflation.
Job openings (https://fred.stlouisfed.org/series/JTSJOL) still seem higher than in pre-COVID booms.
That means it would take a bigger drop in inflation than usual to generate a damaging amount of unemployment.
Are monetary conditions tightening?
The TIPS spread (https://fred.stlouisfed.org/series/T5YIE) is my favorite indicator of monetary conditions. Last week’s drop says those conditions tightened.
We saw a sudden drop in most interest rates, with the conspicuous exception of the rates that the Fed is actively targeting. This suggests that the Fed tightened monetary policy last week, since that’s what it takes to keep the fed funds rate stable when markets are driving rates down.
Keep in mind that tightening isn’t necessarily bad. Deflation that comes shortly after an unexpected burst of inflation causes little pain. The reason for concern is that this looks like an unintentional monetary tightening. The tightening looks like an accidental byproduct of prioritizing, in the short term, stable interest rates, instead of prioritizing stable inflation and growth.
Times of falling interest rates are when the Fed has made its worst mistakes, due to the persistent delusion that falling interest rates imply loose monetary conditions.
How Far is Inflation from the Fed’s Target?
At the start of some of the worst recessions, inflation was clearly too high. E.g. in September 2008 inflation looked like it was running around 5% until the August CPI was released and showed the first CPI number that indicated a sudden deflation. I’m unsure whether anyone was calculating the TIPS spread at the time (that was the first recession for which TIPS data is available). It would have warned the Fed in August that it was about to undershoot its 2% target.
Alas, the Fed seems to prioritize the most official looking data, and in key days in early September 2008, that said that the Fed should still be reducing inflation.
In contrast, today the CPI is showing 3% or less inflation, depending on whether we use 12-month trailing data or a shorter window. Data for the past few months suggest that inflation has dropped below the Fed’s target. So the Fed has much fewer excuses for tightening monetary policy than it did in the fall of 2008.
Indicators of Current Conditions
Here are some indicators of economic conditions that I focus on to provide a more recent picture than government data provides. They’re telling me that we’re not likely to see a 2008-style crash in the next month or two. Beyond that they’re somewhat inconclusive.
The ISM Manufacturing PMI® says that growth dropped to about zero in July.
Commodity prices are more stable than I’d expect to see if the economy were crashing. I’m paying a fair amount of attention to oil, copper, and lumber. I don’t see a clear downward trend yet.
The decline in crypto prices this past week is big enough to worry me a bit. I don’t know how much weight to put on that evidence. Maybe it’s mainly a reaction to Trump’s decline on prediction markets, in which case it says little about the broader economy?
Markets are suggesting that something recently went more wrong in Japan than in the US. I gather that their central bank wants to tighten more than the Fed does. That is likely contributing to the US market decline.
Closing Thoughts
Don’t focus on the binary question of whether we’ll get a recession. The difference between a shallow and a deep recession is more important than whether the economy passes a particular threshold.
One plausible scenario is that reactions to the Sahm rule are functioning the way that portfolio insurance functioned in 1987. Under an optimistic version of that scenario, the stock market would rebound soon, then likely retest this week’s lows in October, and then some sort of rally would resume. Caveat: the economy looked stronger during the 1987 crash.
I bought a small amount of stocks today. I will likely sell some if we get a significant rebound.