The date of the next recession is unknowable, but its impact isn't

The date of the next recession is unknowable, but its impact isn't
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The economy right now is in something of a sweet spot, with growth quite strong and inflation well-contained. Against this happy backdrop, economists naturally have started to think about the next recession; it’s not called the dismal science for nothing.

All economic expansions end in recessions, by definition, but the downturns don’t emerge out of the ether, for no reason.

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Cyclical upswings don’t die of old age. Entrepreneurs don’t tire of inventing things; banks don’t get bored with lending money to make a profit; people don’t stop showing up for work.

 

It’s true that post-war recessions usually have begun within about five years of the start of an expansion, but recent upswings have been longer than in the pre-1990s period and, in any event, there’s no God-given rule of nature determining when the cycle ends.

It’s just that, typically, it takes several years for imbalances to build in the economy, triggering inflationary pressure and forcing the Fed to act. 

Economic expansions, in other words, eventually become victims of second-degree murder, killed unintentionally by the Fed as it seeks to put a lid on inflation pressure.

Fine-tuning the economy with interest rates is impossible, and the policymakers’ focus on backward-looking unemployment and wage data means that the Fed usually ends up raising interest rates too far, suffocating business and consumer spending. 

That point is still some way off on the current cycle because the labor market and inflation data have not been bad enough to force the Fed to raise rates quickly. The further and faster the Fed hikes, the more unpredictable are the consequences and the wider is the range of possible outcomes.

Gently nudging rates up by a quarter-percent every three months isn’t going to test the resilience of the economy for some time yet. 

Higher rates slow by rendering potential new capital spending projects less profitable, or by dissuading people from buying new cars, homes and other major consumer items. The costs of servicing existing debts rises as rates increase too, but right now debt-service ratios are low for both businesses and consumers.

New debt issuance in recent years has been for much longer terms than in the previous cycle, so the rollover into higher rates will take longer than usual too, especially with rates rising so slowly.

In short, then, the Fed has not yet done enough to push the economy into the next recession. But this could change over the course of the next year, if the unemployment rate continues to fall and, especially, if wage increases pick up.

There’s no real mystery about the recent sluggishness of wage growth, compared to previous cycles when unemployment has been as low as it is now. People get paid for what they produce, but productivity growth — output per worker, per hour — has been much slower in this cycle than in the past, reaching a nadir of zero in 2016.

Last year, though, productivity growth rose to 1.3 percent as business investment rebounded, and I’m hoping for an increase nearer 2 percent this year. Businesses don’t buy new equipment and leave it in the box; they put it to work, boosting productivity growth. 

If faster productivity growth were the only story, the Fed wouldn’t have much to worry about. But as the unemployment rate sinks ever lower, employees will be in a much stronger position to push to be compensated for higher inflation, raising the risk that wage gains will eventually become uncomfortably rapid.

In that case, the Fed will raise rates at least as fast their current forecasts — three times this year and three times next year — and probably faster. That will scare banks into slowing the flow of credit, and the economy will turn down.

This is a story for next year, though, or even 2020, and in the meantime, there’s nothing to stop the stock market hitting new highs, on the back of very strong earnings growth.

In the best-case scenario, the Fed might be able to hold fire for longer, if the strength of the economy persuades some of the missing millions of workers to come back into the labor force. I’m hopeful of progress on this front, but the labor participation rate remains obstinately flat.

Firms say they’re desperate to find people to hire, but they still seem to be reluctant to dip into the pool of people who haven’t had a job for some time. 

It should be clear from all this that recession forecasting is more of an art than a science. There will be one, at some point in the next few years, but the timing can’t yet be forecast with any real confidence. Beware of economists banging the table and promising that it’s a dead cert for, say, the third quarter of 2019. It just isn’t.

The only thing I’m confident of is that the next recession will be nothing like the last one, and it won’t break the banking system. Recessions are proportionate, roughly, to the imbalances which precede them, and the economy today looks nothing like the period ahead of the financial crisis.

Fortunately, just because the most recent recession nearly blew global capitalism, doesn’t mean that the next one will too.

Ian Shepherdson is the chief economist and founder of Pantheon Macroeconomics, a provider of economic research to financial market professionals. Shepherdson is a two-time winner (2003, 2014) of the Wall Street Journal's annual U.S. economic forecasting competition.