Thursday, June 6, 2019

This time might not be different

Estimating the probability of a recession over a short horizon has so far proven to be a challenging task for economists. Each cycle looks slightly different from the previous one and trying to come up with precise indicators of crises leads to either overpredicting them or missing their timing as some risks are underestimated. As the US enters its longest expansion ever, we are back to a discussion on whether there are any reliable indicators that can help us forecast the next turning point. 

Without providing an exhaustive list of all candidates, let me highlight the interaction between three statistical patterns and how they inform us (or not) about the risks ahead: 

Three (related) statistical patterns

1. The Yield Curve tends to invert before a recession.


2. The US does not seem to be able to sustain a low unemployment rate. Once we reach "full employment" (or even before), unemployment bounces back as we hit a turning point. I have written about this pattern in my previous post.



3. No US expansion has lasted more than 120 months. Using the NBER business cycle dates, we are about to enter the longest expansion since their data starts in 1857.

These three statistical patterns are related. As an expansion continues, we see both a gradual decrease in the unemployment rate and a flattening of the yield curve. This should not be a surprise, as unemployment declines central banks raise short-term rates. But what is interesting is that the US (so far) has not been able to reach a state where the yield curve remains flat for a long period of time or, equivalently, the unemployment rate stays low for a number of years. Both the slope of the yield curve and the unemployment follow clear V-shape paths. And this is likely to be linked to the length of the expansion: when the recovery starts both unemployment rates and the slope of the yield curve come down from high levels and as they reach their lowest possible levels, they bounce back setting a limit for how long expansions last. In the current expansion, and after 10 years, even if we started with a high unemployment level (as in 2009), we must be very close to full employment (and the yield curve is flat or inverted).

But aren't these just statistical patterns without an obvious causal argument? Correct, but the fact that this statistical pattern is to robust and consistent means that if the US were to continue its current expansion for a few more years it would have to be that "this time was different". 

Can this time be different?

Could it be that the risks or imbalances that led to previous recessions are either not present or just better managed today? Maybe. It is true that the stock market does not look as expensive as in the year prior to the 2001 recession. It is true that housing markets do not look as expensive as the year prior to the 2008 recession. But we need to remember that in those years we underestimated the relevance of those risks. In 2007 US Federal Reserve Officials praised the resilience of the US financial system to a possible fall in housing prices. Are we failing to see other relevant risks today?

And let's not forget that, even ex-post, some recessions are not clearly preceded by excessive imbalances. For example, the 1990 recession. That recession seems to be more an accumulation of smaller risks combined with geopolitical events (such as the invasion of Kuwait by Iraq). And while some of these geopolitical events are difficult to predict, it is not hard to produce a list of the potential threats the world faces today (from Brexit, to the trade conflicts initiated by the US administration, to the potential instability of the Euro area,...).

In summary, statistical patterns suggest that a recession is imminent. Can this time be different because large imbalances are not present? Maybe. But let's not forget the previous times when we did not see the size and implications of the ongoing imbalances. And let's not ignore the long list of potential risks that could materialize and produce a global slowdown that could easily tilt the US and possibly other countries into a recession. This time might not be different.

Antonio Fatas

on June 06, 2019 |   Edit