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Is the USA heading for recession?

It is impossible to make both precise and accurate forecasts of a country’s rate of economic growth, even a year ahead. And the same goes for other macroeconomic variables, such as the rate of unemployment or the balance of trade. The reason is that there are so many determinants of these variables, such as political decisions or events, which themselves are unpredictable. Economics examines the effects of human interactions – it is a social science, not a natural science. And human behaviour is hard to forecast.

Leading indicators

Nevertheless, economists do make forecasts. These are best estimates, taking into account a number of determinants that can be currently measured, such as tax or interest rate changes. These determinants, or ‘leading indicators’, have been found to be related to future outcomes. For example, surveys of consumer and business confidence give a good indication of future consumer expenditure and investment – key components of GDP.

Leading indicators do not have to be directly causal. They could, instead, be a symptom of underlying changes that are themselves likely to affect the economy in the future. For example, changes in stock market prices may reflect changes in confidence or changes in liquidity. It is these changes that are likely to have a direct or indirect causal effect on future output, employment, prices, etc.

Macroeconomic models show the relationships between variables. They show how changes in one variable (e.g. increased investment) affect other variables (e.g. real GDP or productivity). So when an indicator changes, such as a rise in interest rates, economists use these models to estimate the likely effect, assuming other things remain constant (ceteris paribus). The problem is that other things don’t remain constant. The economy is buffeted around by a huge range of events that can affect the outcome of the change in the indicator or the variable(s) it reflects.

Forecasting can never therefore be 100% accurate (except by chance). Nevertheless, by carefully studying leading indicators, economists can get a good idea of the likely course of the economy.

Leading indicators of the US economy

At the start of 2019, several leading indicators are suggesting the US economy is likely to slow and might even go into recession. The following are some of the main examples.

Political events. This is the most obvious leading indicator. If decisions are made that are likely to have an adverse effect on growth, a recession may follow. For example, decisions in the UK Parliament over Brexit will directly impact on UK growth.

As far as the USA is concerned, President Trump’s decision to put tariffs on steel and aluminium imports from a range of countries, including China, the EU and Canada, led these countries to retaliate with tariffs on US imports. A tariff war has a negative effect on growth. It is a negative sum game. Of course, there may be a settlement, with countries agreeing to reduce or eliminate these new tariffs, but the danger is that the trade war may continue long enough to do serious damage to global economic growth.

But just how damaging it is likely to be is impossible to predict. That depends on future political decisions, not just those of the recent past. Will there be a global rise in protectionism or will countries pull back from such a destructive scenario? On 29 December, President Trump tweeted, ‘Just had a long and very good call with President Xi of China. Deal is moving along very well. If made, it will be very comprehensive, covering all subjects, areas and points of dispute. Big progress being made!’ China said that it was willing to work with the USA over reaching a consensus on trade.

Rises in interest rates. If these are in response to a situation of excess demand, they can be seen as a means of bringing inflation down to the target level or of closing a positive output gap, where real national income is above its potential level. They would not signify an impending recession. But many commentators have interpreted rises in interest rates in the USA as being different from this.

The Fed is keen to raise interest rates above the historic low rates that were seen as an ’emergency’ response to the financial crisis of 2007–8. It is also keen to reverse the policy of quantitative easing and has begun what might be described as ‘quantitative tightening’: not buying new bonds when existing ones that it purchased during rounds of QE mature. It refers to this interest rate and money supply policy as ‘policy normalization‘. The Fed maintains that such policy is ‘consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term’.

However, many commentators, including President Trump, have accused the Fed of going too fast in this process and of excessively dampening the economy. It has already raised the Federal Funds Rate nine times by 0.25 percentage points each time since December 2015 (click here for a PowerPoint file of the chart). What is more, announcing that the policy will continue makes such announcements themselves a leading indicator of future rises in interest rates, which are a leading indicator of subsequent effects on aggregate demand. The Fed has stated that it expects to make two more 0.25 percentage point rises during 2019.

Surveys of consumer and business confidence. These are some of the most significant leading indicators as consumer confidence affects consumer spending and business confidence affects investment. According to the Duke CFO Global Business Outlook, an influential survey of Chief Financial Officers, ‘Nearly half (48.6 per cent) of US CFOs believe that the US will be in recession by the end of 2019, and 82 per cent believe that a recession will have begun by the end of 2020’. Such surveys can become self-fulfilling, as a reported decline in confidence can itself undermine confidence as both firms and consumers ‘catch’ the mood of pessimism.

Stock market volatility. When stock markets exhibit large falls and rises, this is often a symptom of uncertainty; and uncertainty can undermine investment. Stock market volatility can thus be a leading indicator of an impending recession. One indicator of such volatility is the VIX index. This is a measure of ’30-day expected volatility of the US stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPXSM) call and put options. On a global basis, it is one of the most recognized measures of volatility – widely reported by financial media and closely followed by a variety of market participants as a daily market indicator.’ The higher the index, the greater the volatility. Since 2004, it has averaged 18.4; from 17 to 28 December 2018, it averaged 28.8. From 13 to 24 December, the DOW Jones Industrial Average share index fell by 11.4 per cent, only to rise by 6.2 per cent by 27 December. On 26 December, the S&P 500 index rallied 5 per cent, its best gain since March 2009.

Not all cases of market volatility, however, signify an impending recession, but high levels of volatility are one more sign of investor nervousness.

Oil prices. When oil prices fall, this can be explained by changes on the demand and/or supply side of the oil market. Oil prices have fallen significantly over the past two months. Until October 2018, oil prices had been rising, with Brent Crude reaching $86 per barrel by early October. By the end of the year the price had fallen to just over $50 per barrel – a fall of 41 per cent. (Click here for a PowerPoint file of the chart.) Part of the explanation is a rise in supply, with shale oil production increasing and also increased output from Russia and Saudi Arabia, despite a commitment by the two countries to reduce supply. But the main reason is a fall in demand. This reflects both a fall in current demand and in anticipated future demand, with fears of oversupply causing oil companies to run down stocks.

Falling oil prices resulting from falling demand are thus an indicator of lack of confidence in the growth of future demand – a leading indicator of a slowing economy.

The yield curve. This depicts the yields on government debt with different lengths to maturity at a given point in time. Generally, the curve slopes upwards, showing higher rates of return on bonds with longer to maturity. This is illustrated by the blue line in the chart. (Click here for a PowerPoint file of the chart.) This is as you would expect, with people requiring a higher rate of return on long-term lending, where there is normally greater uncertainty. But, as the Bloomberg article, ‘Don’t take your eyes off the yield curve‘ states:

Occasionally, the curve flips, with yields on short-term debt exceeding those on longer bonds. That’s normally a sign investors believe economic growth will slow and interest rates will eventually fall. Research by the Federal Reserve Bank of San Francisco has shown that an inversion has preceded every US recession for the past 60 years.
 
The US economy is 37 quarters into what may prove to be its longest expansion on record. Analysts surveyed by Bloomberg expect gross domestic product growth to come in at 2.9 percent this year, up from 2.2 percent last year. Wages are rising as unfilled vacancies hover near all-time highs.
 
With times this good, the biggest betting game on Wall Street is when they’ll go bad. Barclays Plc, Goldman Sachs Group Inc., and other banks are predicting inversion will happen sometime in 2019. The conventional wisdom: Afterward it’s only a matter of time – anywhere from 6 to 24 months – before a recession starts.

As you can see from the chart, the yield curve on 24 December 2018 was still slightly upward sloping (expect between 6-month and 1-year bonds) – but possibly ready to ‘flip’.

However, despite the power of an ‘inverted’ yield in predicting previous recessions, it may be less reliable now. The Fed, as we saw above, has already signalled that it expects to increase short-term rates in 2019, probably at least twice. That alone could make the yield curve flatter or even downward sloping. Nevertheless, it is still generally thought that a downward sloping yield curve would signal belief in a likely slowdown, if not outright recession.

So, is the USA heading for recession?

The trouble with indicators is that they suggest what is likely – not what will definitely happen. Governments and central banks are powerful agents. If they believed that a recession was likely, then fiscal and monetary policy could be adjusted. For example, the Fed could halt its interest rate rises and quantitative tightening, or even reverse them. Also, worries about protectionism may subside if the USA strikes new trade deals with various countries, as it did with Canada and Mexico in USMCA.

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Surveys and Data

Questions

  1. Define the term ‘recession’.
  2. Are periods of above-trend expansion necessarily followed by a recession?
  3. Give some examples of leading indicators other than those given above and discuss their likely reliability in predicting a recession.
  4. Find out what has been happening to confidence levels in the EU over the past 12 months. Does this provide evidence of an impending recession in the EU?
  5. For what reasons may there be lags between a change in an indicator and a change in the variables for which it is an indicator?
  6. Why has the shape of the yield curve previously been a good predictor of the future course of the economy? Is it likely to be at present?
  7. What is the relationship between interest rates, government bond prices (‘Treasuries’ in the USA) and the yield on such bonds?