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Recessions in a post-inflation world

Summary:
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,

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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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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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