Is the US economy heading for a recession?

Luke Bartholomew  0:06  
Hello, and welcome to Macro Bytes, the economics and politics podcast series from abrdn. My name is Luke Bartholomew. And this week, we will be talking about the risks of recession in the US economy. And I suppose, by extension, the global economy, too. And of course, this comes in the context of, I think growing perception that the Fed had fallen somewhat behind the curve in terms of dealing with underlying inflation pressure in the US. And that means that there is going to have to be quite significant degree of monetary tightening over the next couple of years. And unfortunately, history is not replete with examples where the Fed has been able to pull off or indeed other central banks have been able to pull off the kind of smooth landing, where they're able to tighten policy, just enough to bring inflation risk down, but not so much that they deliver a recession, accidents happen quite a lot. And on top of that, we're facing a huge energy and oil price shock to which has also been associated historically with elevated recession risks. So I think these risks of a US recession are very real and pressing and very important for investors to consider at the moment. And so I'm delighted to say we're joined today by James McCann, Deputy Chief Economist, and Abigail Watt, research economists, both of which are based in the US to help us think through these issues. So guys, thanks so much for joining us today. So, James, I think perhaps before we dive into sort of conversations around exactly where the US economy is right now, and how we might go about measuring and tracking, recession rescue, it'd be helpful to take a step back and ask, I hesitate to say a more basic question, but potentially a more basic question of sort of, why is it that these tend to be played with any sort of cyclical movements over time of booms and busts? Why do we sometimes have recessions?

James  2:09  
Thankfully, you can. Yeah. Sounds like a simple question. But actually, I guess, I guess, rather rather complicated. Kondratiev, a Russian economist was writing about this pretty seminal piece 100 years ago, and he spoke about waves of activity. So you can read waves and your longer term cycles, in part, centred around changes in technological process. Now, the thinking around business cycles has obviously emerged significantly since that point and developed. Now, I think, a stronger and more fundamental understanding, although there's not full consensus on what the nature of the cycle looks like. But I think your point around shocks is particularly important to cycle can be running along, and it can face any kind of shock, be it, you know, very, very topical at the moment in energy, price shock or another form of macroeconomic shock. And that can cause the cycle to reset. And that's a nice way of saying you, you go from growth, you go from expansion into recession. Now, what we do find is that there are points potentially along that cyclical path of which that cycle can be considered more vulnerable to those types of shock. And I think that's what's really important. And we'll probably get on to a little bit today, when we're trying to predict how cycles evolve. So we know that as cycles, age and mature, they can develop certain vulnerabilities or imbalances that make them more susceptible. When the shocks do occur to going into into downturns in very simple terms, an economy can, can run out of kilter. So activity can for a period of time be running, really in the red of the period where it's difficult to sustain. And that can create its own its own pressure points in the economy, we can see financial imbalances builds, and they too, can introduce their own their own vulnerabilities. So I think when we think around business cycles, we know that typically the end on account of shocks, but we also know that the end, because of other features that have become inherent during that expansion, and I think monitoring, both of those are particularly important when we're trying to predict how business cycles might evolve and think, think about the future the risk of recession.

Luke Bartholomew  4:20  
Yeah, and I think this point about ageing and maturing is a very good one. Because, you know, as the cliche goes, business cycles don't die of old age, they tend to be killed. But it's also true that overtime, sort of imbalances do tend to build up as you described there. And so time does have an important component in thinking about recessions, which makes it quite surprising, I suppose, in some ways that we're talking recession risks at the moment, given the you know, it was just two years ago that the US suffered a world historical contraction in economic activity around the pandemic. So in some senses were sort of seemingly relatively fresh into this cycle. Two years on, so maybe Abi that's a good time to bring you in to talk sort of, you know, why is it that the pandemic recession was such that already we find ourselves once again, talking about recessions at this point?

Abi  5:12  
Yeah, the pandemic recession was kind of unlike a traditional business cycle downturn. We didn't necessarily see, you know, the eve of the crisis being characterised by buildups of kind of large scale macroeconomic or financial imbalances, which kind of James has already said, as a kind of common driver, a kind of cyclical downturn. The other thing that it makes it quite unique is the speed with which the kind of recession occurred and the the speed with which the recovery occurred. And both of those factors kind of lead us to believe that, you know, the next cycle will likely be shorter in length. And that's because of kind of two key reasons. The first is that the before the pandemic related recession, we were seeing rising risk of recession in the US towards the end of 2019, we did see kind of yield curve inversion, some of those traditional signals of increasing recession risks arising and it's not necessarily the case that the pandemic related recession would have unwound some of the imbalances that were already building in the US economy before that recession occurred. So they that's because the kind of speed of the recovery was so much quicker in this downturn as well. So that's the kind of two key reasons why this cycle might be slightly, I guess, might be shorter in land.

Luke Bartholomew  6:34  
Yeah. Okay. I think that's that's well explained. And James, I suppose, one of the thing that we've talked about many times on this show is that the pandemic itself was associated with quite a large supply shock, and that has had inflationary consequences in terms of, you know, as the economy has opened up, and demand has run against some of those supply constraints. And that's created a bit of the inflation environment I was talking about at the start. So maybe it'd be helpful if you could just sort of again, paint that picture of sort of the inflation dynamics we're seeing and what that means for policy at this point in the cycle.

James  7:06  
Exactly. You know, I think when we spoke about imbalances to kick this conversation off, you could say that inflation is a critical symptom of other fundamental imbalances is the way that the economy is try and equilibrate. Again, the price mechanism is a strong and clearly one, which is closely followed but a way of the economy trying to work out some of these stresses. And, you know, we think that this is a symptom, as you say, of an economy, which is actually doing much better than expected from a demand demand perspective, if we look at job growth, for instance, it's been incredibly robust through this cycle, and not just during those periods in which the economy was essentially being turned on and off during lockdown since and through the recovery, as well. So spending has been strong labour demand has been strong. And that is interacted, we think with, you know, what's really been a series of supply shocks, some some home baked here in the United States, so people not being willing or wanting to go back into the labour force that contributed to a tighter labour market as well. And some being more international in nature, we obviously know that supply chains have been severely disrupted, and the complex and an integrated nature of those chains means that it's not so easy to get over small hiccups. And, you know, those, we're still feeling the effects of those interruptions, and that's translating alongside strong demand into incredible price increases for a range of durable goods. So yeah, absolutely. I think this, you know, the speed of the cycle and Abby flagged, we're seeing inflation sort of corroborate that, because relatively early on, we're starting to see this this classic symptom that you're starting to feel these pressures and an imbalance has been created in the economy. I guess the key now is that the Fed is, as you mentioned, that the star Luke, under pressure to catch up and then adjust policy itself. And this speaks to your point that, you know, traditionally we talk about Central Bank's killing the cycle, that might be a little bit unfair in some regards. It's certainly certainly probably true, though, that their adjustments are risky and uncertain. And certainly, the Feds attempt to engineer a soft landing is going to attempt to engineer a soft landing, but the risk that that policy adjustment is miscalibrated, or just needs to be stronger and more forceful, I think, is material. So you know, absolutely. We're entering a tricky, a tricky juncture at present.

Luke Bartholomew  9:27  
So I think that sets the scene perfectly in a sort of a qualitative sense of the risks we're facing. But Abby, I know that you've done a lot of work and thinking about, you know, how we can sort of take those qualitative insights and model them quantitatively how we can actually send something a bit more precise about recession risks and track those through time. So maybe you could just talk a little bit about that, you know, how we think about modelling recession risks and trying to put a number on these considerations.

Abi  9:55  
Yeah. So in terms of how we would model recession risk that by thing is you need to define what a recession actually is. And quantitatively. So in our models, we use the National Bureau of Economic Research his definition of recessionary periods in the US historically. And the reason we use that definition is because they look at the kind of the debt, the diffusion, and also the duration of the slowdown in a number of economic indicators, rather than just focusing on kind of a more traditional definition of a recession, which might be two consecutive quarters of negative GDP growth. So we choose to use that measure, because we think it's kind of slightly broader in it's definition of what a recession actually is. And then once we have that definition of recessions, we then have to think about series which might be correlated with the onset of recessions. And to do that, we would kind of look back historically at the kind of recessions that have occurred in the US and try and think of the reasons why they might have occurred. So for example, we've already touched upon the kind of oil price shocks. So including variables such as the oil price is kind of one way in which we would try and predict recessions. But also the the other kind of more traditional measure, which would be the yield curve is kind of a commonly followed harbinger of recessions as well. And then we also would include kind of other measures of kind of activity across the economy as well. So we would include measures of kind of labour market tightness, as James has already alluded to, in terms of economic capacity, are we seeing kind of a positive output gap, that's something that we would maybe include in the recession with models, and then also those kind of traditional imbalances. So things like household and corporate debt, looking at kind of housing market indicators, and then also financial market variables, such as equity returns. So once we've collected kind of this, these two key pieces of information, we have our definition of a recession, and then we have all these variables that we think are correlated with the onset of a recession, then we would put those into a kind of quantitative framework, and we would model, the impact of the changes that we're seeing in the kind of variables are correlated with recessions, on the kind of occurrence of recessions. And when we do that, we can focus in on kind of single variable models. So we can say, what's the basis of the, you know, the probability of a recession on the basis of the yield curve alone, or we could look at multivariable models where we're saying if we combine the risks across all of the variables, what's the probability of a recession, and when we're doing this, we like to kind of look ahead, so we calibrate the models so that we are predicting the probability of a recession and within 12, or 24 months from the prediction date.

Luke Bartholomew  12:47  
Super, before I let you get to the punch line of, you know, what recession risks look like, at the moment in the US, it might be worth very quickly saying that the yield curve is this, you know, this relationship between, you know, what governments borrow the short term versus the long term. And typically, we expect this curve to be upward sloping. So borrowing longer in the future has a higher interest rate than borrowing short term, but then sort of as recession risks increase, it tends to be the case that that curve flattens and perhaps even invert, so it costs more to borrow short term, rather than long term. And this has been sort of historically quite a good leading indicator of recession risks for various reasons. So I just want to just explain to listeners, what this yield curve concept was there. But as I say, why don't why don't I let you know, sort of get to the punch line of how we sort of using that quantitative framework, think about recession risks, at the moment.

Abi  13:44  
At the minute on based on the kind of most recent data that we have. In the US economy. We're predicting that in the period out to kind of January 2023, recession risks are around 20%. But when you push that further out, recession, risks rise up to around 30%. And then because of the framework we use, we can get an understanding as to which variables might be pushing that recession risk higher. And when we when we look at that, it's interesting to see that things like leak vehicle sales kind of softer consumer sentiment, and also rising oil prices are contributing to recession risks at the minute in the US. And it's it's natural that we would maybe it's that some of these will improve in the coming months. So for example, in terms of vehicle sales, these these numbers might start to to recover as we see kind of some of the supply chain disruptions, easing in the auto sector, and in the coming months. However, things like the kind of oil price signal have obviously worsened since we've probably since we ran these models. And so that's one risk that we would flag in terms of possibly providing a higher risk of US recession going forward.

Luke Bartholomew  14:58  
Yeah, it will work stressing that 25 to 30% recession risk over the next couple of years is elevated. And that feels quite scary as and as I said at the start, hence this sort of sense of this is an important pressing risks. So perhaps James, maybe a good question on that note, then it's to ask you, I mean, what things could happen that would reduce that risk? Abi talked a little bit about some of the indicators that we would be looking at that more structurally, given how things are set up in terms of Fed policy and the risks around inflation, what things are we looking for that would perhaps at a deeper level, you know, bring some of those risks down a little bit?

James  15:37  
Yeah, absolutely. I think, you know, we think one of the issues is the economy has has slipped into an imbalance. So there are imbalances which have emerged across important sectors and now, creating these nasty symptoms of inflation. I guess the really encouraging a really encouraging sign would be if some of those imbalances would start to easy, independence of some policy intervention. Now, we know a bunch of the imbalances relate to the COVID pandemic, we know, there's been a big drop in labour force participation, because people are less confident going into the workplace during during the global pandemic, it's possible that views on that change as vaccination rates continue to gradually rise or as people get more used to it, or as we make a transition from pandemic towards endemic living. So it's possible that that helps, you know, similarly, it's uncertain around when some of the stresses in global supply chain start to ease but it's possible we get surprised to the upside there and not just not just with the supply side improving, it's possible to that some of the demand for goods, as you know, it's been very strong during the pandemic starts to rotate back towards services. Again, this relates to the switch from from pandemic, to endemic living - people are more comfortable going to restaurants going on, on holiday, etc. And so they spend less on durable goods and more on regular services. These are the sort of, I guess, relief valves, which would independent of policy intervention starts really, really help out and moderate some of those inflationary pressures. And it will probably mean that the Fed will be less inclined or under less pressure, at least to tighten as aggressively. And I think through that channel, you could see some of these recession risks started, start to ease somewhat. So if this crisis has been a story of relatively strong demand, followed by disappointing supply. Now, one of the the avenues to make this this imbalance less risky, I suppose is an improvement in in some of those supply side, and particularly, as we sort of move out of the COVID pandemic. So that's something we're watching pretty closely.

Luke Bartholomew  17:49  
Okay. So I think the key takeaway there is that, you know, this is a pretty tight rope that the Fed has to walk across in terms of delivering this policy tightening and anything that the supply side could do to help out I think, would be very warmly welcomed at this point, both by investors and policymakers more generally. So I think that is all we have time for this week. So all that remains is for me to thank Abigail and James, for joining us today and their excellent insights. And of course to thank you guys, for listening. Please do subscribe and like us on your favourite podcast platform. And we will speak to you again soon. Thanks very much.

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