A Contrarian View On The Next Recession Consistent With Historical Precedent

Two of the most heavily-debated topics over the last month are: 1) the Fed tightening into what certainly looks like a deflationary spiral, and 2) plunging crude prices.

Clearly, the latter could well exacerbate the disinflationary impulse, thus raising the chances that the Fed has made a policy mistake.

Ostensibly, the argument for hiking now (if you’re the Fed) is to preempt a scenario wherein the overheating labor market ends up translating into sharply higher realized inflation down the road. In other words, in the “who you gonna believe?” situation in which we now find ourselves, the Fed will listen to the labor market and assume that eventually it will become clear that inflation was “lying.” At that juncture, the Fed will be vindicated and will be able to proudly assert that they did not fall behind the proverbial curve.

In the meantime, the non-proverbial curve (that is, the yield curve) is collapsing, which seems to suggest that the Fed might be miscalculating.

But the real reason the Fed is trying to squeeze in a handful of hikes may have more to do with persistently loose/easy financial conditions. So far, hiking rates has failed miserably when it comes to actually “tightening” things up (so to speak) and the inevitable result is that while real economy inflation is low, asset price inflation is running rampant. So the Fed is trying to prick some bubbles.

Well let’s say, for argument’s sake, that the labor market is correct and that inflation will eventually pick up. What would happen, in that scenario, if oil prices were to rise on the back of an improving fundamental backdrop?

I recognize the latter scenario seems unlikely given recent price action and given the current rather supply-ish outlook for crude. But more than a few people have suggested that at some point, all of this money printing is bound to translate into inflation which leads one to wonder what might happen to the economy in the event crude rises just as other inflation pressures start to build and manifest themselves in the headline data while rates are still, for all intents and purposes, at crisis levels.

Consider that along with the following commentary from Goldman, who notes that “the most frequent contributors to modern recessions have been monetary policy tightening and oil price shocks.”

Via Goldman

Relying on several historical sources, we identify the key contributors to each recession. Exhibit 3 summarizes our findings. We draw four lessons. First, the most frequent contributors to modern recessions have been monetary policy tightening and oil price shocks, with the former in response to inflation that often gained momentum from the latter. Second, sentiment-driven swings between over-borrowing and heavy investment followed by deleveraging and investment cutbacks contributed to the two most recent recessions and also played a role in early recessions, especially during boom-and-bust cycles of railroad investment. Third, while the financial sector has not been the origin of as many modern US recessions, it was a very frequent source of early US recessions. Fourth, fiscal policy shocks have sparked US recessions, but only in the context of demobilizations from major wars.

We can also look beyond US history using a similar taxonomy of the sources of advanced economy recessions from the IMF. The IMF identifies five key contributors to 122 recessions since 1960: fiscal policy shocks, monetary policy shocks, oil price shocks, external demand, and financial crises. Their classification is based on statistical rules-of-thumb and assigns multiple factors to some recessions, but none to others. This global perspective highlights a couple of additional lessons. First, oil shocks and monetary policy tightening have become less frequent contributors to recessions globally in recent decades. Second, even before the Great Recession, financial crises were a fairly common source of modern advanced economy recessions

Goldman says that the “the dominant cause of postwar US recessions–rapid rate hikes in response to high inflation, often boosted by oil shocks–is less threatening today due to the anchoring of inflation expectations and the rise of shale.”

That’s duly noted, but boy wouldn’t it be funny if after all the global hand-wringing about structural disinflation and, more recently, structurally low crude prices, the next recession ended up resulting from exactly the combination of factors that’s contributed to other modern recessions: rapid tightening into an inflationary environment catalyzed by an oil price shock…

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