The season is upon us, and for many, that means holiday parties filled with small talk about what we do for a living. For me, that usually means answering the same question several times a night: “Will we have another recession?”
As an economist, it’s one of my favorite questions and always reminds me of a story about J.P. Morgan (the banker not the bank). At the end of a particularly stressful day at the New York Stock Exchange, a group of reporters is said to have cornered Morgan outside of his office, excitedly asking, “What will the markets do this year?”
Without missing a beat, Morgan gave a three-word interview that may be the only 100 percent foolproof prediction ever made about financial markets.
“They will fluctuate.”
I love that story because it reminds me of how little can often be said around the economy or financial markets with 100 percent certainty even among the most skilled forecasters.
In light of that fact, it also helps to influence my response whenever I’m asked about the next recession. The only thing that I can say with 100 percent certainty about the next recession is … there will be one. Though the “what” is easy, the “when,” “where,” “why” and “how” are much more difficult predictions to make.
We are economists, however, and a little uncertainty has never stopped us from making predictions before. So here are three reasons why the odds of another downturn are becoming uncomfortably high as we head into the New Year.
Reason No. 1: The Job Market
This might seem counterintuitive at first given how well the job market has been doing over the past few years. In fact, the U.S. unemployment rate is the lowest it has been in 50 years. How can that be an indicator of an impending downturn?
Historically, the job market has a tendency to get a little too hot just before a recession. In fact, in every downturn since World War II the U.S. unemployment rate has fallen below what economists would call “full employment” about three years before a recession.
The problem with using this as an indicator of recessions is that economists can very rarely agree on what the full-employment unemployment rate is. Conventional economic wisdom says that full-employment currently sits somewhere around a 4.5 percent unemployment rate.
We are now at the leading edge of the longest period of expansion in modern American history, and that’s a long time for us to go without screwing something up.
By that metric we blew through full employment roughly two and a half years ago, putting another recession directly on the horizon. Even if we assume, as many economists already have, that full employment is much lower than 4.5 percent, we’re still likely to hit the three-year mark by the end of 2021, keeping recession watchers on high alert.
Reason No. 2: The Yield Curve
The yield curve is something that a lot of people have heard of, but very few actually understand. The reason so many have heard of it, and the reason you’ve probably seen it discussed so much in the financial press lately, is that it is one of the most historically accurate predictors of recession.
The yield curve is the difference between long-term interest rates and short-term interest rates, and it matters to financial markets because it is a useful indicator of how banks make money. Banks make money by borrowing money via your savings account at a relatively low, short-term interest rate, and then lending that money to your neighbor at a relatively high, long-term interest rate.
However, sometimes short-term rates can actually be pushed higher than long-term rates, causing what’s called an inverted yield curve. An inverted yield curve can make lending much less profitable, and when banks stop lending the economy usually stops growing.
It’s difficult to say with any certainty whether an inverted yield curve is a cause or merely a symptom of an eventual recession, but what can be said is that inversions in the relationship between 10-year Treasury yields and three-month Treasury yields have successfully predicted U.S. recessions better than any other indicator since WWII.
Once the yield curve inverts for a considerable amount of time, a recession has followed within 12 to 23 months 100 percent of the time. This past spring the yield curve inverted to its deepest depths since 2006, casting an ominous shadow over the next two years.
As with the labor market, the yield curve is something on which economists cannot always agree. In fact, there are several economists putting forward some very intelligent-sounding theories even today about why the yield curve cannot be relied upon to predict the next recession.
However, if you were to go back and read the financial press before each of the last three or four recessions, you would find articles littered with reasons why “this time is different,” and you would also find that every one of those theories was wrong.
Bottom line, while it’s certainly possible that this time really is different, friends don’t let friends doubt the yield curve.
Reason No. 3: It’s About Time
Any economist worth his salt will tell you that economic expansions don’t die of old age. However, we are now at the leading edge of the longest period of expansion in modern American history, and that’s a long time for us to go without screwing something up.
Economic indicators are becoming more and more convincing that we are at or at least very near the top of the business cycle, and it doesn’t take a degree in economics to tell what comes after the top.
Looking at data from across the country, more than 70 percent of metro areas by GDP can be said to be in late-cycle expansion. The last time that could be said of anywhere close to 70 percent of the country was in early 2007, approximately 11 months before the Great Recession.
A recession in 2020 is still far from a sure thing, but it would be simply extraordinary in light of these three factors if we were able to make it much beyond the end of next year without some kind of economic slowdown.
The implications of any slowdown in economic growth would be major not only in our every day lives but on the 2020 election as well, particularly here in Pennsylvania, which has become a swing state for the first time in decades. Our relatively diversified economy has a tendency to track the national business cycle very closely. If the U.S. falls into recession by year’s end, then Pennsylvania likely won’t be far behind.
The only thing still missing from the recipe for a recession is some type of economic shock or imbalance that can push us over the edge. While there are plenty of candidates out there — from trade to impeachment to an overvalued stock market — nothing looks imminent within the next few months.
But keep in mind that that’s exactly what we usually say just as that shock or imbalance is forming.
Here’s to a very interesting New Year.
Dan White is an economist in West Chester, PA. He directs public sector research at Moody’s Analytics and teaches economics at Villanova University. The views expressed in this article are his alone and do not necessarily reflect those of his employers. @DanWhiteEcon
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