“None of the U.S. expansions of the past 40 years died in bed of old age,” MIT economics professor Rudiger Dornbusch famously observed in 1997. “Every one was murdered by the Federal Reserve.” Researchers tend to agree, as shown by numerous studies that link inverted yield curves with economic contractions. But does the history of the business cycle and monetary policy in the decades prior to the Great Recession of 2008-2009 still resonate today? In other words, what are the odds that the next recession will be a byproduct of monetary policy decisions, intentional or otherwise?
I’ve been running such questions around in my head for a while, pondering why and how the business cycle could make another trip to the dark side. There’s minimal risk on that front at the moment, as last week’s review of indicators suggest. But assuming that the business cycle hasn’t been repealed (a reasonable assumption, to say the least), we’ll see another downturn one day. But given the Fed’s extraordinary efforts of late in keeping that risk to a minimum, is the probability of a new recession lower than it might otherwise be?
It’s an interesting question for a number of reasons, starting with the fact that the central bank’s posture is somewhat unique, particularly for this stage in the business cycle. It’s been four years since the last recession ended and yet monetary policy, at least by the standards of history, is unusually accommodative. One clue is the year-over-year real (inflation-adjusted) change in the monetary base, which was higher by roughly 20% through last month vs. a year ago. That’s not all that high relative to the last several years, in the wake of the economic and financial crisis of 2008-2009. But in the grand scheme of modern Fed history it’s fair to say that Bernanke and company are pumping up the monetary base at an unusually high pace.
Looking at the chart above inspires the question: Can we have a recession if the monetary aggregates are rising at a robust clip? If the Fed is actively determined to keep the economy out of the cyclical ditch, are the odds favorable for thinking that it’ll succeed? I ran the question by Robert Dieli, an economist who publishes macro research at NoSpinForecast.com. He says that if we take the Fed out of the picture as a real and present danger for the business cycle, it’s only prudent to look for other catalysts that could trigger a recession. Not surprisingly, there’s no shortage of possibilities. But as Dieli reminds, we don’t live in an economic vacuum. Whatever scenario you can dream up for risk factors that could, in theory, push the economy over the edge, the question becomes: How would the Fed react?
Meantime, there are few, if any, smoking guns in the here and now, starting with the biggest kid on the block. “There’s a list of things you hear when the Fed is on the warpath, and we’re not seeing any of those,” Dieli says. Indeed, the yield curve isn’t inverted, nor is it anywhere close to being inverted. As of yesterday, the 10-year Treasury Note’s yield is 2.61% vs. roughly zero for a 3-month T-bill. Never say never, but for now it’s hard to fathom how short rates could move over a 10-year rate any time soon in the current climate.
Some analysts say that looking at the yield curve and related measures is no longer relevant because the Fed is “manipulating” short rates. Isn't that always true? In any case, some economists say that the reliability of the yield curve as a risk factor in business cycle analysis has been rendered null and void. But is this circular reasoning?
It’s clear that recessions in the past have been associated with tighter monetary policy. But that factor has been taken off the table for the foreseeable future, which implies that recession risk is low. Yet some analysts look at a positively sloped yield curve and say that it no longer matters, which amounts to arguing that it’s different this time.
Perhaps. But if it is, we should expect to see some trigger (or triggers), apart from tighter monetary policy, that elevate recession risk. In that case, would the Fed respond? Could it respond? If you accept that the central bank’s monetary policy can be effective when the policy rate is zero, then the answers to those two questions are likely to be “yes” and “yes.”
All of which brings us down to the real question: Can we have a recession if the Fed is keenly focused on keeping one at bay? No one really knows the answer, in part because the Fed has often been a key factor, perhaps the leading factor, in causing recessions. But this time really could be different.
Imagine that in six months we see a chain of events that scares the heck out of consumers and retail spending drops like a rock. In turn, that leads to a deep round of layoffs and unemployment starts moving higher in rapid fashion. The Fed sees this and rolls out a new and aggressive round of quantitative easing. Does that nip the recession in the bud?
There are a number of reasons for thinking that the Fed would be successful in heading off a cyclical attack. But in the realm of macro one can never really be sure. In some sense we’re in uncharted territory. The expansion, modest and unsatisfying as it is, is now 48 months old, by the NBER’s accounting. That’s still below the average expansion since World War II, which weighs in at 58 months. According to the Dornbusch doctrine, age has nothing to do with recession risk. But if the Fed isn’t a risk factor, what does that say about the business cycle for the foreseeable future?
In some sense it’s back to the drawing board. What are the causes of recessions generally? Economists have never really come up with a satisfying answer, which is probably one reason why recessions are a constant through time. Sure, we can point to the telltale signs, such as rising unemployment, lower spending, and tighter monetary policy. But what’s the source of those changes? If you spend any time looking for robust answers, you quickly realize that cause and effect in this corner of economics is a bit like walking in a house of mirrors.
This much, at least, is clear. If we do have a recession while the Fed is aggressively trying to avoid one, we’re in deep trouble.