I would argue that it makes sense to talk about a Goldilocks economy yet still worry about the longer-term downside risk of recession. These are conflicting narratives, yes. But they don’t have to be. Let me explain how I think about them below
The superlatives of Goldilocks
First, take a look at this brief list of superlatives about the US economy I just pulled together:
- GDPNow for the last quarter shows a whopping inflation-adjusted anticipated growth of 4.5%.
- Real GDP growth is due to hit 3% in year-over-year terms for the only the second period since 2006.
- The headline unemployment rate hit the lowest level in 49 years in May.
- “Global initial public offerings (IPOs) for tech firms are off to their hottest start since the dot-com bubble in 2000.” – Quartz
- Private equity funds are raising money at the fastest rate in more than a decade. – FT
- The tech-laden Nasdaq stock index hit an all-time high last week.
Folks, this is a boom. It’s as good as it gets, frankly. If the economy ran any hotter, it would overheat.
But it’s not overheating. Minneapolis Fed President Neel Kashkari made the case well in a post yesterday:
inflation expectations appear well-anchored, the economy is not showing signs of overheating and rates are already close to neutral. This suggests that there is little reason to raise rates much further
Steady growth? Check. Low unemployment? Check. Low inflation? Check. And Fed Presidents are making the case to stop raising interest rates.
Goldilocks. What’s not to like?
Moderation is a fatal thing. Nothing succeeds like excess
Animal spirits are endemic to capitalism. So we’re not going to get rid of the business cycle. That’s why you should be concerned when I list a whole bunch of superlatives about the economy. Those superlatives are sowing the seeds of this cycle’s destruction.
You’ve heard the dictum that “stability breeds instability”? That’s a nugget from the late economist Hyman Minsky. It was his version of Oscar Wilde’s “moderation is a fatal thing” quote. What he’s saying is that human beings adjust to boom times by expecting more boom times. And so they seek more risk, believing the margin for error can be reduced due to the boom.
So booms are about forgetting moderation and swinging for the fences. Look at the fine print I highlighted in bold the FT article on Private equity, for example:
Private equity groups are raising money at the fastest rate in more than a decade. Buyout executives are rushing to tap investor demand just as fears grow of a market correction….
“Funds are rushing to raise money while the music is playing,” said a fundraiser for mid-market private equity groups. “People fear missing out.” However, with the PE industry already having an estimated $3tn in cash to invest, there is concern that buyout funds may end up overpaying for assets and eroding the potential returns for their investors.
That’s clear excess. You’re not going to raise record amounts of cash and just sit on your hands. PE companies are going to put that money to work. And they are going to do so with a very small margin of error to make profits.
So when is the recession, then?
Seeing this boom move into excess – whether it’s record IPOs, faster PE cash raising, billion dollar scooter rental companies, or skyrocketing rents in Midland, Texas – makes one fear downside risk. And the ultimate symbol of downside risk is economic recession.
How should we talk about the likelihood of and the triggers for a recession?
Here’s an example from University of Oregon Professor Tim Duy that is pretty good:
Bond markets are caught between a Federal Reserve determined to push short rates higher while demand stays strong for longer dated safe assets. The result is a relentless flattening of the yield curve. It is now easy to see the 10-2 spread inverting by then end of the year, an event that has traditionally been the harbinger of recession.
An inversion would certainly raise my attention with regards to the possibility of recession, but be careful on the timing. The 10-2 spread is a long leading indicator. The earth will not shake when that spread inverts. There will not be a plague of frogs. Blood will not rain from the sky. From the perspective of policy makers, the lack of immediate economic implication means it can be easily dismissed. And in my opinion that dismissal is the soil in which the seeds of the next recession are sown.
Powell & Co. will find it impossible to resist the siren song of the data near the peak of a business cycle. When the hikes continue after the yield curve inverts is when I go on recession watch.
But again, timing is everything. Because the inverted yield curve is a long leading indicator, equities easily might continue to rise in the period after the inversion but before the recession. Hence, the inversion would likely be a premature “sell equities” signal.
Bottom Line: The U.S. economy retains substantial momentum, easily sufficient for Powell & Co. to stick with their gradual plan of gradual rate hikes. That plan has to date flattened the yield curve just like in every tightening cycle as long rates have held stuck near three percent despite every reason to think they will move higher. I don’t expect this situation to change, and hence expect that on the curve will continue to flatten as long as the Fed continues to hike rates. An inversion is likely at some point in the foreseeable future. The Fed is likely to continue hiking after that inversion – and that is the point at which I would look for storm clouds on the economic horizon.
That’s how the Goldilocks story turns into a bear market mauling
Tim’s right. You should expect the curve to invert soon. And that inversion won’t be an unmistakable signpost of recession. It will be a harbinger of slowing though. And likely, the Fed will downplay it, keep on raising rates, and face the consequences of doing so.
It’s been some eight months since I wrote about this as the most dangerous period in the business cycle. And since then, things are playing out largely as expected. As I put it then:
this is the Fed’s real conundrum this late in a business cycle. If the economy is running solidly and leading economic indicators are bullish, the Fed is hard-pressed to not raise rates in an environment in which headline unemployment is low and falling, asset prices are rich, and lending standards have loosened — even if the yield curve is flattening. Aren’t they supposed to take the punch bowl away?