Is the Recession Saga Finally Over?

Most predictions were for the American economy to slip into a recession in 2023. It didn’t happen! Will it happen in 2024? It could, but most likely not per the prevailing view.

In this post, I will summarize the recession saga that has played out during the last three years and conclude with some takeaways.

Recession

A recession, characterized by a decline in aggregate economic activity, traditionally involves at least two consecutive quarters of negative GDP growth. In the United States, the National Bureau of Economic Research, the official referee of recessions, flags recessions by considering not just GDP but also other economic indicators such as jobs and consumer spending.

To be proactive, everyone from investors and entrepreneurs to jobseekers and policymakers would love to get a heads-up on an upcoming recession.

Unfortunately, predicting recessions is dicey. There is no one magic formula. Economic analysts track a combination of leading economic indicators, such as employment levels, corporate profits, and business investment, that change before the aggregate economy changes to flag a potential shrinkage of the economy.

Recession Cause

The “imminent” recession of 2022/2023/2024 has its roots in the pandemic when the federal government and the Federal Reserve, God bless their hearts, put fiscal and monetary policies in overdrive to prevent economic collapse. That worked well, but the policy pilots didn’t take their feet off the gas at the right time, especially at the Fed.

The Fed Chairman, Jerome Powell, miscalculated the inflation implications of the Fed’s ultra-loose monetary policy. By the time he realized his mistake, it was too late, and the inflation train had left the station.

A remorseful (I think) Powell put on his sternest, no-nonsense, bespectacled face and vowed to stamp out inflation come what may. And he froze that facial expression for months and, in the process, froze the hearts of many equity market participants.

The Fed’s challenging task of raising interest rates speedily and significantly to curb economic activity and dampen the jobs market sparked a debate about whether, in controlling inflation, the economy would contract into a recession.

Initially, given the soaring inflation and an overheated job market, the thought was that a recession was almost inevitable.

What Happened?

The economy did not crumble! In 2022, a recession appeared to have occurred when the economy contracted in the first two quarters, but other economic indicators were healthy.

Eventually, little happened in 2022, and contrary to expectations, there was no recession in 2023 as well.

While a few regional bank failures occurred in 2023, policymakers effectively contained any potential contagion. Notably, the GDP did not decelerate but accelerated during the first three quarters of 2023. The unemployment rate remained below 4%, and consumer spending was strong.

Confronted with declining inflation, a resilient GDP, and robust employment levels, many economists who had initially predicted a recession are now predicting a slowdown but not a recession in 2024. Some retained their recession projections, albeit with a “mild” disclaimer.

This week (December 13, 2023) brought a new twist—the Fed anticipates reducing interest rates thrice in 2024 (this is what prompted me to write this post). This information punctured those predicting a 2024 recession based on the assumption that the Fed would have to keep rates elevated for a long time.

But wait a minute. There’s also a flip side. The Fed had decided not to rest until it tamed inflation and now plans a rate-cutting spree, suggesting that economic contraction is a greater risk than inflation. The possibility exists that the Fed’s interest reduction moves might not stem a potential economic contraction.

Incorrect Prediction

Why did most analysts wrongly predict a recession even though most leading indicators did not signal a recession? Blame it on the yield curve inversion, which occurs when short-term rates exceed long-term rates. This signpost has historically signaled an impending recession within the next 12 to 18 months (see notes for a simple explanation).

The tendency of herding behavior among analysts and the influence of the inversion possibly led to the widespread prediction of an economic downturn. In defense of analysts, the yield inversion was not fleeting but long-lasting.

Takeaways

Take recession forecasts with a grain of salt. There’s a valid reason for the quip about economists predicting six of the last two recessions.

The pandemic changed many of us. I know it changed me. It may have changed our spending habits and attitudes toward risk. The shift in our consumption attitudes and patterns has made us less interest rate sensitive.

The yield curve inversion tells us what bond investors think. In an earlier blog post (read here), I suggested we shouldn’t put bond investors on a pedestal to the extent we do. Bond investors are not always the economic oracles they are made to be. If the yield curve inversion comes a cropper, we should become less venerative of bond investors.

Finally, we could have a few plot twists in 2024, so don’t rule out anything. The only thing sure in the economy is uncertainty. Stay braced.

Note

Imagine you have to make business loans to someone for two years and ten years. For which of the two loans will you charge a higher interest rate? Typically, if you lend your money for a longer time, there’s a greater risk you might not get it back, so to compensate for the higher risk, you will seek a higher return.

Now consider a situation where you believe the state of the economy, in terms of things like jobs and business profits, will be grim over the coming two years. Because you are incredibly nervous about the short-term, you might want a higher interest rate for your two-year loan than for your ten-year loan. In other words, if you believe it will be a riskier environment over the next few years, you are willing to accept a lower rate for the safety of the longer-term ten-year investment.

Yield inversion occurs when the US Treasury two-year note (read about the US Treasury market in the Notes section of this post) yields more than the ten-year note. In this instance, the bond market’s message is—caution, turbulence ahead. Past data shows that a recession typically follows in 12 to 18 months.