EDITOR'S NOTE: For all the uncertainties that abound in the economy, here’s an equation that you might consider consistent if not predictable: Inflation surges > Fed raises rates to attempt a “soft landing” > soft landing fails > Recession. This pattern has been repeating itself consistently since after WWII. The tricky part is in timing the turns. What signs indicate that the Fed’s instrument panel might be getting shaky and unwieldy as it attempts to gradually cool the economy? What sectors might best indicate an acceleration point in the economy’s slowdown? The authors at Calculated Risk have pinpointed a few factors that they believe call the turns ahead of time; sort of like road signs. The key to timing this supposedly predictable cycle is to pay close attention to them, as each turn is a blind curve.
In that 2013 post, I wrote:
The next recession will probably be caused by one of the following (from least likely to most likely):
3) An exogenous event such as a pandemic, significant military conflict, disruption of energy supplies for any reason, a major natural disaster (meteor strike, super volcano, etc), and a number of other low probability reasons. All of these events are possible, but they are unpredictable, and the probabilities are low that they will happen in the next few years or even decades.
Unfortunately, in 2020, one of these low probability events happened (pandemic, emphasis added), and that led to a recession in 2020.
2) Significant policy error. Two examples: not reaching a fiscal agreement and going off the "fiscal cliff" probably would have led to a recession, and Congress refusing to "pay the bills" would have been a policy error that would have taken the economy into recession.
We've seen several policy errors over the last several years, mostly related to immigration and trade during the previous administration, but none that would lead the economy into a recession.
1) Most of the post-WWII recessions were caused by the Fed tightening monetary policy to slow inflation. I think this is the most likely cause of the next recession. Usually, when inflation starts to become a concern, the Fed tries to engineer a "soft landing", and frequently the result is a recession.
And this most common cause of a recession is the current concern. With inflation picking up due to the pandemic (stimulus spending, supply constraints) and now due to the invasion of Ukraine, the Fed will embark this week on a tightening cycle to slow inflation.
One of my favorite models for business cycle forecasting uses new home sales (also housing starts and residential investment). I also look at the yield curve, but I've found new home sales is generally more useful. (See my post in 2019: Don't Freak Out about the Yield Curve)
The arrows point to some of the earlier peaks and troughs for these three measures.
The purpose of this graph is to show that these three indicators generally reach peaks and troughs together. Note that Residential Investment is quarterly and single-family starts and new home sales are monthly.
Note: the New Home Sales data is smoothed using a three month centered average before calculating the YoY change. The Census Bureau data starts in 1963.
1) When the YoY change in New Home Sales falls about 20%, usually a recession will follow. An exception for this data series was the mid '60s when the Vietnam buildup kept the economy out of recession. Another exception was the recent situation - we saw a YoY decline in new home sales related to the pandemic and the surge in new home sales in the second half of 2020.
If the Fed tightening cycle will lead to a recession, we should see housing turn down first (new home sales, single family starts, residential investment). There are other indicators too - such as the yield curve and heavy truck sales - but mostly I'll be watching housing. (I'm not currently on recession watch)