ILCB - Recession Risk - Expecting The Unexpected

2023-07-10 13:17:00 ET

Summary

• It’s possible to enter a period where recession clearly becomes increasingly likely, even as it remains exceedingly difficult to predict the timing of a recession with any confidence.
• An extremely soft landing would allow inflation to fall while growth continues and unemployment remains below 4%.
• The Fed is forecasting a rise in unemployment to roughly 4.5%. That sort of moderately soft landing might be called a “mini-recession”.
• Policy failure is much more likely under an anti-inflation regime than under a normal regime. A bit too tight and you end up in recession. A bit too easy and the high inflation continues.

Both of the following might be true:

1) A recession became much more likely after 2021.

2) During any given year, a recession is unlikely.

I’ll use a numerical example to illustrate the way I think about recession risk.

Assume that during normal times, the Fed aims for steady NGDP growth, say 4%/year. Because the Fed is a bit “clumsy”, actual NGDP growth fluctuates over time. Let’s suppose that 30% of the time the growth rate is at least 2% too high, and there’s also a 30% chance that it’s at least 2% too low. There’s a 10% chance that NGDP growth is at least 4% too high, and a 10% chance that growth is at least 4% too low.

Now assume that a more than 4% drop in NGDP growth leads to a recession. In that case, there’s a 10% chance of recession in a given year during normal times.

Now assume that inflation has become a big problem. The Fed knows that a 4% drop in NGDP growth leads to recession, so they aim for a “soft landing”. They hope to reduce NGDP growth by 2% each year. Now there is a much higher risk of recession. A mere 2% error to the downside causes NGDP growth to fall by 4%, triggering a recession. The risk of recession rises from 10% to 30%. That’s still not particularly high, but if the anti-inflation policy is done two years in a row, then the recession risk rises to 51%. Over three years, it’s over 65%.

To summarize, it’s possible to enter a period where recession clearly becomes increasingly likely, even as it remains exceedingly difficult to predict the timing of a recession with any confidence.

The term “soft landing” can be defined in several different ways. An extremely soft landing would allow inflation to fall while growth continues and unemployment remains below 4%.

The Fed is forecasting a rise in unemployment to roughly 4.5%. That sort of moderately soft landing might be called a “mini-recession”. It might seem odd to forecast a mini-recession, as (AFAIK) the US has never experienced that phenomenon. Unemployment always rises by less than 1% (percentage point) or more than 2%. But that seems to be roughly what the Fed is aiming for, and lots of other countries have had mini-recessions. There’s no obvious reason why we could not have that outcome.

The recession scare of 1966 offers another lesson. In that case, the Fed failed so badly in its attempt to bring down NGDP growth that they ended up overshooting to the upside in 1967-68 (after a brief dip in 1966). This illustrates an important point - policy failure is much more likely under an anti-inflation regime than under a normal regime. A bit too tight and you end up in recession. A bit too easy and the high inflation continues. There’s far more room for error under a normal regime. Thus, NGDP growth slowed a couple percentage points in 2016 without triggering a recession (but it did cost Hillary the election.)

All macro models are wrong, including the one I provided here. In reality, NGDP misses are not normally distributed. If my model were exactly true, then the US would have more mini-recesisons than outright recessions. But we haven’t had any mini-recessions. Errors on the contractionary side can easily snowball into a sharp downturn, due to the Fed’s flawed policy regime (lack of level targeting).

Nonetheless, this numerical example illustrates a few points that recession forecasters in the media don’t seem to grasp. Just as it’s really hard to predict when a bus driver will accidentally steer a bus off the road, it’s difficult to predict when the Fed will accidentally steer NGDP growth too slow (or too fast). On the other hand, just as buses are more at risk on narrow mountain roads, the economy is more at risk when he Fed is engaged in an anti-inflation policy.

Fed policy actually seems roughly on track at the moment, even though the policy regime remains highly flawed. In other words, the central point in the distribution of possible outcomes is a roughly appropriate slowdown in NGDP growth, but the distribution is much too wide due to the Fed’s flawed policy regime. I’m worried about both recession and high inflation.

How could the Fed make accidents less likely? How can they reduce the “fat tails” in the NGDP growth distribution? How can they become less “clumsy”?

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P.S.: Soon the US will announce a big drop in 12-month CPI inflation, to the low 3s. Don’t believe the hype - inflation remains a big problem. Base effects.

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