Was it right to be on recession watch in 2016?
We are now three months into 2017 and we can look back on 2016 as a fairly good year economically for the US. The numbers for Q4 have now now been updated to show growth at a 2.1% annualized pace, bringing year-on-year growth up for the second quarter and back into the 2%ish growth path we had been on before the oil capex meltdown derailed the economy.
So given that backdrop, was it right to worry about a recession in 2016? And what does that say about 2017? Here’s my view below.
Back in June, when the economy was at its lowest ebb I wrote a post on just this topic. At the time, I wrote, “when I look at the same data for medium-term clues, I still see reasons to be concerned, and, therefore, I continue to be on recession watch. Finally, I am not at all sure the Fed sees the picture as I do. December was a policy mistake. And I can’t rule out others going forward.” Let me unpack this a bit and update you on my thinking.
First, I was saying in early 2016 that while recession wasn’t a base case, the US economy had decelerated so much that it was at stall speed and we had to be concerned. The way I looked at it, none of the near term data said recession was coming. Nevertheless, a cautious approach would still have been to be on the lookout for clues that pointed to further weakness.
The way the economy performed in 2016 – moving decidedly down away from the 2% growth path to 1.2% annualized growth by Q2 but then re-accelerating – vindicates that view.
The Fed, in the end, did see things my way. December was a one and done hike, followed by caution throughout 2016. It was only in December of 2016 that the Fed hiked again. Using hindsight, I would say that Janet Yellen has done as well as could reasonably be expected in charting the course for policy normalization given the divergent views on rates on display at the Fed and in financial markets.
Of course, now we are in a different atmosphere, where more hikes are coming. Today, the PCE inflation index popped up to 2.1%, exceeding the Fed’s inflation target for the first time since 2012. Boston Fed President Eric Rosengren made the case even before those data were released that we could see 4 hikes this year, instead of the three the Fed has been signalling.
Now the markets had only been putting even odds on a second rate hike by June. So the concept that we would get four hikes this year would shock the market. But this kind of uncertainty is part and parcel of policy normalization. I mean, if the Fed is truly data-driven, then its forward guidance when it is hiking should be more uncertain. After all, the part of the business cycle when rates are going up is a part of the business cycle during which there should be less certainty about the economic path. And a truly data-driven Fed, hiking due to incoming data, adjusting the medium-term outlook for employment and inflation, is one that hikes in a more unpredictable way.
Of course, if the economy is good, then this should lead to a steepening yield curve as term premia increase due to policy uncertainty, making long-lived assets relatively less attractive. Yield curve flattening tells us that something is not quite right about this picture though. To me, it speaks to caution, the same caution I justifiably had in 2016.
Again, nothing in the data says recession. But there are signs like the curve flattening, slowing consumer spending and auto credit delinquencies that suggest it is not full steam ahead for the Fed. The real question is whether the Fed sees 3 or 4 hikes as accommodative when it was putting in a 25 basis point hike every meeting in the middle of last decade – or 8 hikes a year. I think it does. That means the risk is for more than three hikes rather than fewer.