When the recession occurs, it is likely to be mild.
When the recession occurs, it is likely to be mild. One rationale is that U.S. banks are well capitalized and recently underwent the recession stress tests. The other is U.S. economy doesn't have imbalances usually associated with severe recessions[...]
The Federal Reserve’s actions to accelerate the pace of interest rate hikes in the past quarter has had a notable impact on financial markets. Treasury yields have doubled since the start of this year and the bond market posted the first negative double digit returns in four decades. Meanwhile, both Nasdaq Composite and Russell 2000 indexes have fallen decidedly into bear territory while S&P 500 index is down by 20%. It marks the worst half year results in 50 years.
From this perspective, it is clear that Fed tightening is an event with which investors must contend. It remains to be seen whether a U.S. recession will follow, though, given the close association between increases in the federal funds rate and recessions as shown in the shaded areas of the chart below.
The Federal Funds Rate and U.S. Recessions, 1950 to mid-2022
In the midst of the current debate over a "hard" or "soft" landing for the economy, it is useful to consider the post-war experience with bear markets. One of the most famous quotes about stock market's ability to predict U.S. recessions is by Paul Samu
In 2016, Steve Liesman of CNBC updated the findings and found that Samuelson’s quip still held: There had been 13 bear markets in the postwar era then and seven recessions within twelve months, with bear markets giving investors about eight months lead time before a recession began. Assuming this pattern still holds, one might infer there is a 50:50 chance of a recession beginning by early next year.
To get a better idea of how things are now, it is important to consider how the current environment compares with others.
The closest example is the recession that began in December 1969 and ended in November 1970, which marked the end of a decade-long expansion that saw inflation rise from 1 percent in the early 1960s to 5 percent at the end of it; The Fed responded to inflation buildup by raising funds rate from 6.5 percent in mid-1968 to a peak of 9 percent by late 1969, which resulted in a mild decline of real output less than 1 percent and an increase in unemployment rate from 3 to 6%. This experience illustrates how high rates had to rise both nominally and real terms to induce a mild recession.
Today, the main difference is that CPI inflation has spiked to a forty-year high of 8.6% (6% ex food and energy). This reflects supply-chain shortages linked to the Covid-19 pandemic as well as highly accommodative fiscal and monetary policies to counter it. Investors are now worried that because the Fed was slow to respond to the pickup in inflation, it may overreact.
The fed funds rate at present is very low historically at 1.75%-2.0%. If the Fed reaches 3 ½% by next year, it would mean that interest rates could be negative in real terms then. Investors should keep in mind that no recession has begun when real rates were negative.
If the Fed were to raise interest rates further, a recession would be triggered. The main risk would be if core inflation remained high in the range of 4%-5%. In that case, the Fed would have no choice but to initiate another round of tightening; that could result in a funds rate that is even higher than it is now. The market's failure to price this into its forecasts could lead to additional declines.
If a recession were to happen, investors would need to determine whether it would be severe and lengthy or short and mild. Those who predict a steep downturn believe that the bursting of the bubble in asset markets - stocks, bonds and real estate - and the ensuing loss in wealth will compel households to reduce spending, while firms will fire workers.
Yet, this did not happen during the bursting of the tech bubble, in which the S&P 500 index plummeted by nearly 50% over two and one half years. The collapse of the dot com bubble was accompanied by one of the mildest recessions on record – with real GDP falling by less than 1% from March 2001 to November 2001 while the unemployment rate rose from 4% to 6%. The Federal Reserve raised the funds rate from 4.75% to 6.5% by mid mid 2000 and subsequently lowered it to 1% in mid 2003.
In contrast, the
When viewed from this perspective, there are several reasons to believe that if a recession unfolds, it is likely to be mild. One is that U.S. banks are well capitalized today and recently passed recession stress tests. Another is that the U . S . economy does not face major imbalances when severe recessions usually appear in them.
Because of these factors, my conclusion is that Fed tightening will be more of a market event than an economic event in which there is a prolonged recession.