KRWG

Predicting A Recession? Sorry, That's Not Reliable

Jul 6, 2018

Commentary: If you watch financial news, as I do, you no doubt have been witness to a flood of comment about the end of the expansion. Analysist are talking about the “late cycle.” Discussion turns to “inverted yield curves” and the coming recession.

Extremely low unemployment leading to wage pressure, tightening monetary policy and a looming trade war all have put analyst on the lookout for a recession. Mechanically speaking, we are late in the cycle in that we are in the midst of one of the longest expansions on record and is  now tied for the third longest expansion on record.

Despite this growing consensus of a pending recession, in fact, predicting business cycle turning points remains a very difficult thing to do. Take for example, the fact that the expansion is getting long in the tooth. Since 1945, we have had 11 expansions, lasting an average of 58 months. At 108 months, pundits argue, the current expansion will soon die of old age

But expansions are not like grandfathers. They do not get old and die. Economists have studied this issue thoroughly. We have looked at every which way we can. How old the expansion is has no effect on the probability of a recession. That an expansion is 10 months or 10 years old has no impact on the chance that this is the month that the recession will start.

Doom-and-gloomers point to the stock market as an indication of a recession. The S&P 500 is done from its January peak by about 11%. It is true that the stock market is the best single predict of future economic activity. Stock prices reflect the prospect of the companies underlying the stock. So looking at aggregate stock prices summaries the total prospect of the underlying economy.

But while a good predictor, stocks are not a prefect predictor. For example, raising wages is good news for the economy but is bad news for corporate profits. So higher wages can result in a falling stock market despite improved economic conditions.

Besides, while the S&P is off from its all-time high, it is still 6% higher than a year ago, hardly a sign of impending disaster.

Another factor that the doom-and-gloomers point to is a flattening yield curve. The yield curve is the relationship between short-term and long-term interest rates. Normally, short-rates are less than long-term rates so that the yield curve slopes upward—the longer the time to maturity, the higher the rates.

When the Fed tightens monetary policy, they do so by raising short-term interest rates. At the same time, tighter monetary policy lowers future inflation. Since expectations of inflation are a major factor determining long-run interest rates, tight monetary policy lowers long run rates.

So short-term rates up; long-term rates down. The yield curve can invert so that long term yields are less than short-term yields. When this happens, it is an indication that Fed has gone too far. The result is often a recession.

To hear the doom-and-gloomers, we already have an inverted yield curve and a recession will be the inevitable results. This is not true. The yield curve remains as is usual with short-term rates less than long-term rates.

Just because the doom-and-gloomers have overstated their case, doesn’t mean they don’t have a point. The Trump trade war could well push the economy into recession. And there is a real possibility that the Fed could over correct, pushing us into a recession. But then, we always face the possibility of recession, when the recession will come is just not easy to predict.

Christopher A. Erickson, Ph.D., is a professor of economics at NMSU. He has taught money and banking for more than 30 years. The opinions expressed may not be shared by the regents and administration of NMSU. Chris can be reached at chrerick@nmsu.edu