We are nearly nine years away from the end of the last recession, a much longer than average spell of economic expansion. I am not forecasting a recession in the next three years, but that's not comforting: Professional economists have a poor track record of forecasting recessions. The month before the last recession started, December 2007, economists surveyed by The Wall Street Journal estimated only a 38 percent risk of a recession starting in the next 12 months.
Dr. Bill Conerly based on data from The Wall Street Journal
Risk of Recession
Although I am not predicting a recession to begin in the next year, I recommend a recession contingency plan to all of my clients. It does not have to be detailed. I suggest a single page of notes on the steps to take. If indicators of an upcoming recession become more pronounced, then senior managers should each sketch out a one-page plan for their areas of responsibility.
Understanding the likely cause of the next recession will help companies evaluate their own vulnerability. Monetary policy hurts interest sensitive sectors the most, whereas oil shocks hurt energy intensive sectors, and foreign recessions hurt exporters most. The most likely cause of our next recession is monetary policy error by the Federal Reserve, with other possible causes much less likely.
Monetary policy has been at fault in most of the post-World War II recessions. Although the Fed was created to stabilize the economy, it has not met that goal. There is nothing wrong with the people running the Fed. I've met many of them, including a Fed chair, members of the Federal Reserve Board, reserve bank presidents and staff economists. They are all bright, well-informed people who sincerely want to help. But they cannot consistently stabilize the economy. We have too complex an economy, driven through decisions made by 325 million Americans as consumers, workers, entrepreneurs and government officials. Our economy also interacts with seven billion people around the world.
The billions of decision-makers are considering changes in their economic circumstances, changes in technology, in their own and others' attitudes, new tax and regulatory policies, and new competition, both for resources and for sales. This is too much complexity to manipulate into stability.
In practical terms, the next recession will most likely be triggered by the Fed tightening credit conditions, through raising short-term interest rates and maybe also selling some of their securities portfolio.
Time lags may confuse the Fed into continuing to tighten too long and too hard. The time lags are several: the lag between monetary policy action and the real economy (spending, production and employment); the lag between changes in the real economy and changes in inflation; and the lag between when this happens and when we see data reporting it has happened. The time lags will give the impression that monetary policy is not working at dampening inflationary pressures, so more tightening is needed. Milton Friedman spoke of "the fool in the shower." The water was too cold, so he turned up the hot water. But nothing happened right away, so he turned the hot faucet even higher. And even higher. Finally the hot water kicked in and the fool was scalded. He turned down the hot and turned up the cold. Still he was scalded. He kept turning the cold up, until finally - nothing but cold water, and he was shivering again.
The Fed may think its policy isn't working, keep dialing it up, and then find it has scalded the economy. One reason for this error is that changes in the financial system can change the potency of monetary policy as well as the time lags. The Fed can never be sure of just how much cause will lead to how much effect, and when. To make things more complicated, most economic models put monetary policy in tandem with fiscal policy (government spending and taxes), so the Fed must also consider how its policy will interact with budget actions.
The Fed has a very difficult job. It's no surprise, nor any insult to the Fed, to say that they won't do a perfect job every year. We'll get a recession, though I'm not sure when.
The second most likely cause of a recession is an oil price shock, but it's second by a long way from monetary policy. Oil shocks played a significant role in the recessions of 1973-75 and 1980, with minor roles in other recessions. An oil shock was more likely when OPEC was a major player in oil supply decisions, so I'm less worried about this now than I was before the shale oil boom.
A bubble bursting is on many minds, but recessions are seldom caused by bubbles. The 2008-09 recession was certainly caused by excessive housing construction and speculation, but that's the only one. The recession of 2001 is often attributed to the dot-com bust, but don't forget the huge buildup of capital spending in anticipation of Y2K, and the subsequent wind-down in spending after January 1, 2000.
This isn't to say that a stock market crash couldn't trigger a recession, but it's unlikely. Very little current spending is tied to wealth in the stock market. Most consumer spending correlates with income much more than net worth. Business spending can drop due to a weakening stock market, but that's a very small part of capital spending decisions.
The next largest threat I see right now has little historical precedent: trade war. We had an awful trade policy adopted in 1930, the Smoot-Hawley Tariff, and it certainly hurt the economy. But there was so much other bad policy going on that it's wrong to pin the Great Depression entirely on the trade war, though it was certainly an aggravating condition. Nonetheless, we could be in for something new in the way of bad news. Imagine two leaders posture going into negotiations, and each makes worse and worse demands, and the each leader's incalcitrance hurts the other leader's ego. My best estimate is that President Trump will go to the edge of disaster, make a small deal, then step away from danger and declare victory. But this is a forecast of Donald Trump's behavior, which I am hardly qualified to make.
Somewhat related is the possibility of a U.S. recession being triggered by a foreign recession. Our own downturn would certainly be milder than our counterparty's recession, so it would have to be a doozy to bring our economy down. Either China or Europe could conceivably trigger a U.S. recession. China seems the more likely candidate, given that we can place little trust in their economic statistics, nor their understanding of how their own economy works. But China has been growing for many years now, with strong underlying forces propelling them forward. A recession is certainly possible, but probably not one big enough to pull us down into recession.
Other possible causes of a recession are far less likely.
In an upcoming article, I'll look at signs that would indicate an imminent recession.