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Over the past two years, most economists have predicted a US recession. Indeed, it has been the most widely anticipated recession that didn’t happen. Like Godot, it has been a no-show.
That became increasingly obvious at the start of this year. However, while most bailed on their gloomy recession forecasts, many predicted that the Federal Reserve would have to cut interest rates several times to avoid a recession if inflation continued to moderate. That prediction also looks to be wrong, and more economists are now talking about a “higher-for-longer” interest rate outlook.
It was logical to expect a recession over the past two years. After all, the Fed raised the federal funds rate by 5.25 percentage points between March 2022 and July 2023. Surely, it seemed, such a significant tightening of monetary policy would cause something to break in the financial system, unleashing a credit crunch that would then cause a recession. When that happened, the Fed would be forced to lower interest rates quickly. This was the modus operandi of most of the monetary policy cycles since the 1960s.
There were lots of reliable indicators that signalled a recession was coming. The yield curve spread between the 2-year and 10-year US Treasury notes inverted during the summer of 2022, with the shorter term rates rising above longer term ones. It had done that just ahead of previous recessions. The Index of Leading Economic Indicators peaked at a record high during December 2021 and has been falling since then through April, signalling a recession. The growth rate of real M2 — a measure of money supply — on a year-over-year basis turned negative during May 2022, and remains negative through March.
But this is why I think economists were so wrong and those indicators turned out to be misleading:
Past recessions have been mostly caused by credit crunches, spiking oil prices, or bursting speculative bubbles. The inverted yield curve accurately anticipated a financial crisis this time as in the past. There was a banking crisis during March 2023, but it didn’t last very long, and it didn’t cause a credit crunch because the Fed responded quickly with an emergency liquidity facility for the banking sector. The price of oil did spike after Russia invaded Ukraine in February 2022 but ample global supplies and weak global economic growth brought it down quickly. The price of oil rose again during March as the war between Israel and Hamas showed signs of turning into a regional conflict but has since fallen back.
The economy also turned out to be more resilient than economists expected, mostly because consumer spending continued to grow. Many households benefited from higher rates on their bank deposits and money market funds. Many also had refinanced their home mortgages at record low rates during 2020 and 2021.
Most importantly, the baby boom generation has started to retire with a record $76tn in net worth. They are spending on restaurants, cruises, travelling and healthcare. All these services industries have been expanding their payrolls, thus boosting real incomes, and fuelling more spending. The goods sector of the economy has been in a growth recession since about March 2021, following the buying binge that occurred when the lockdown was lifted. Nevertheless, spending on goods has remained at a record high on an inflation-adjusted basis.
Elsewhere, tight monetary policy has been offset by very stimulative fiscal policy. Federal deficits have been widened by lots of federal government spending on infrastructure and federal government incentives for onshoring. The federal government’s net interest outlays have soared, which has boosted personal interest income to a record high.
Corporate profits and cash flow have also held up very well. Capital spending hasn’t been depressed by higher rates because many companies raised funds and refinanced when borrowing costs were very low in 2020 and 2021. Capital spending also has been boosted by onshoring as well as lots of spending on technology hardware, software, and research and development. As a result, productivity growth rebounded last year and should continue to be strong.
And what about the Index of Leading Economic Indicators? It hasn’t worked so well because it is heavily skewed towards the goods economy, which has been relatively weak, and it doesn’t give enough weighting to the services sector, which has been strong.
Economists need to recall that history doesn’t always repeat itself and doesn’t always rhyme. They should rely less on leading indicators and other simplistic models and more on common sense.
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