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The Odds of a Recession In The Next 12 to 18 Months Are Likely

recession next 12 to 18 months
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EDITOR'S NOTE: How likely is a recession in the next 12 to 18 months? If you follow mainstream financial news, the outlook probably feels like a coin toss, with half of the experts forecasting an economic slowdown while the other half is claiming that we’re experiencing the stages of a soft landing. The notion of a coin toss is bad enough, but according to an economist cited in the article below, it’s more like an astrological prediction. The economist considers the “science” of economics a more respectable version of astrological fortune-telling. If predicted outcomes were considered proof of an economist’s craft, then it indeed attests to the notion that myth and faith trump objective reality. So, if you’re looking to read the article below to get yet another opinion on the likelihood of a recession, the author at least provides you with a few strong points as to why you should read optimistic forecasts with a strong dose of skepticism.

Economist Ezra Solomon once observed that the “only function of economic forecasting is to make astrology look respectable.” Historically, economists have had a terrible track record when it comes to making growth forecasts.

The Federal Reserve (Fed) during the 2007-2016 period had a tendency to persistently overestimate future GDP growth. After correcting for this tendency in the recent past, Fed officials found themselves making a new set of costly forecasting errors during the past year. They persistently underestimated inflation. 

“It’s difficult to make predictions, especially about the future,” is a particularly apt adage when it comes to forecasting business cycle turning points. A 2018 International Monetary Fund study looked at 153 recessions in 63 countries between 1992 and 2014 and found that the vast majority were missed by economists. In fact, the study found that forecasters predicted only five out of 153 recessions in the year prior to the actual downturn.

Accurately predicting economic recessions in a timely manner is no easy task. Besides dealing with a complicated and messy world, economists must consider the feedback loop. As Adam Shaw observed: “If a meteorologist says it will rain, the fact that you take an umbrella out with you does not affect the weather. But if an economist forecasts that inflation will rise by 3% and we react by asking for at least a 3% rise in wages, we have changed the basis on which the forecast was made. Inflation is now likely to rise by more than 3%.”

Beliefs and sentiments can influence the behavior of economic agents. A Richmond Fed report noted: “Consumers who are nervous about their future employment or worried that an imminent stock market correction would wipe out a substantial chunk of their savings might be reluctant to make big purchases and take on new debt. The resulting fall in consumption would then lead to an economic contraction that validates consumers’ worst fears.”

Does this mean economic forecasting is a futile exercise that has little to offer investors and business leaders? Not necessarily. There is still considerable value to be attained if an objective and careful appraisal of underlying economic trends leads to useful and actionable insights.

For instance, back in July 2021, I noted: “It is hard to justify today’s ultra-low yields on long-dated Treasuries based on fundamentals unless we are headed for a period of dramatically weaker growth that is accompanied by extremely low inflation, an outcome that appears unlikely. Rationally, we should expect yields to rise going forward”. Since then, yields on the benchmark 10-year Treasury note have surged from around 1.3 percent to over 3 percent.

At the start of this year, I expressed concern about asset prices: “The potential for a sharp and disruptive swing in asset values cannot be ruled out if faster than expected monetary tightening is required to adequately cool the economy in order to ease upward price pressures. Furthermore, at some point, the Fed will be forced to undertake quantitative tightening measures aimed at reducing its $9 trillion balance sheet. Such actions will affect the risk-free rate along with the equity risk premium and term premium and potentially deflate financial asset bubbles.” Events of the past few weeks have largely followed the above script.

Economic forecasting is an inherently imprecise exercise and generally lacks the certitude of scientific predictions. But, as the above examples make clear, the potential for someone to offer thoughtful insights and useful prognostications still exists.

Looking ahead, there are multiple harbingers that suggest a reasonably high likelihood of a U.S. recession occurring in the next 12 to 18 months. First, the extent of monetary tightening needed to bring inflation under control implies that financial conditions will tighten significantly enough over the coming year to sharply raise the cost of credit to households and businesses. Given the starting point of this particular tightening cycle, the odds of a hard landing are rather high.

Second, high oil prices have presaged most U.S. recessions since 1970. If the G-7 goes through with a ban on Russian oil imports, then global oil prices are likely to remain elevated for the foreseeable future.

Furthermore, U.S. natural gas prices have already soared to 14-year highs and are expected to rise even more if supplies are diverted towards Europe. U.S. and global food prices are likely to remain elevated as well. Persistently high food and energy prices will ultimately lead to some demand destruction.

Third, the yield curve is expected to invert as short-term rates catch up to longer-term yields in the coming months. This is quite likely as the Fed now plans to hike its policy rate at a more aggressive pace. Inverted yield curves have a reasonably good track record of forecasting recessions.

Fourth, consumer surveys indicate potential headwinds. The growing gap between the Conference Board’s consumer confidence index (which is dominated by lagging indicators) and the University of Michigan’s consumer sentiments index (which emphasizes inflationary concerns) often portends a recession.

Finally, a sharp slowdown in the global economy is likely given the ongoing geopolitical turmoil in Europe, the stalling of the Chinese economy and the threat of a currency/debt crisis in some emerging markets. Economic woes abroad may have a blowback effect on a U.S. economy that is already facing record-high trade deficits.

All in all, the odds of a recession over the next 12 to 18 months are quite high. Hopefully, it will be a brief and shallow recession.

Originally published on The Hill.

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