“Recession obsession” has become a fixture of markets over the past three months thanks in no small part to the perception that the Fed has tightened the economy into a slowdown just as the tailwind from fiscal stimulus is set to wane.
We’ve variously argued that market participants began to lose track of their own role in shaping the narrative sometime in late November. The curve inversions that started showing up early last month added a sense of urgency to the recession calls and Jerome Powell’s tone deaf press conference seemingly underscored the notion that the Fed wasn’t “feeling the market” – to quote Trump. Now, the protracted government shutdown is lending still more credence to the slowdown story.
When the recession obsession started to set in in earnest last month, analysts were quick to note that the narrative was starkly at odds with the economic data. Of course markets are forward-looking, but the disconnect between how equities and credit (for instance) were acting and the data was so glaring that even pessimistic strategists found it difficult to reconcile.
The problem, of course, is that when everyone loses track of their own role in the narrative, the potential exists for things to become self-fulfilling, as sour sentiment begins to manifest itself in real economic outcomes which in turn feed back into sentiment in a pernicious loop.
It’s against this backdrop that Goldman is out with a sweeping look at historical recessions and their causes. The analysis is familiar (especially to anyone steeped in the economic literature) but it’s worth highlighting some excerpts and visuals.
Goldman begins by listing what the bank calls “the five major causes of US recessions since World War I”. They are:
- industrial sector shocks and inventory imbalances;
- oil supply shocks that reduce real income and generate inflationary pressures;
- inflationary overheating that leads to an aggressive tightening of monetary policy;
- financial imbalances and asset prices crashes; and
- fiscal tightening.
The gist of Goldman’s note is that the first three causes listed above have become less likely to play out, while the fourth (financial imbalances and asset prices crashes) is still an issue.
Most of this is intuitive, which is nice because that means it lends itself to a quick summary and easy paraphrasing.
Predictably, a lot of the analysis is couched in terms of the Great Moderation. Goldman notes that US industry has become less cyclical over the years thanks to improvements in supply-chain management and final demand forecasting. Additionally, cyclical sectors of the economy have obviously become less important, where that means they comprise a smaller share of GDP.
Goldman goes on to note that the US economy is now less vulnerable to oil price shocks due to several factors, not the least of which is rising US energy production and the ability of shale to respond to exogenous supply shocks.
On monetary policy, Goldman flags a flatter Phillips curve and well-anchored inflation expectations. “In past decades, labor market overheating generated substantial inflationary pressure [and] high inflation tended to persist because inflation expectations were poorly anchored and adaptive to recent experience'”, the bank notes, adding that “as a result, persistent labor market overheating led to accelerating inflation, forcing the Fed to respond with aggressive rate hikes.” With a flatter Phillips curve, that dynamic has changed, permitting the Fed to allow the labor market to run hot without being forced to step in with the kind of aggressive policy response that chokes off growth.
Skipping straight to the “good” part, Goldman warns that the risk of financial imbalances and asset price bubbles is still pervasive and indeed, is a consequence of the Great Moderation. To wit:
As economists first took note of the Great Moderation twenty years ago, some— including the GS team at the time—cautioned that the new era had a dark side: long periods of expansion can foster the buildup of leverage and financial imbalances in the private sector, making the economy more vulnerable to credit crunches. Credit crises and asset bubbles have been the main source of recession risk in the US since then, and an IMF study found that financial crises were also a fairly common cause of recent recessions across other advanced economies, even before 2008.
Here Goldman flags the usual suspects (financialization and the growing interdependence of international markets) as presenting an “in principle” risk of a recession brought about by financial imbalances and the bursting of asset bubbles.
The good news is that the private sector is (ostensibly anyway) in “good shape”, and currently runs a financial surplus of 4%. “This is comforting because the private sector financial balance has been a very good predictor of financial crises, as shown in Exhibit 11, and at average levels indicates fairly limited risk”, Goldman notes.
Of course this is, at heart, another way of saying that in the post-crisis era, risk has been shifted from the private sector to central bank balance sheets, which presumably will need to be unwound with consequences that are as yet unknown. Indeed, that is arguably the question of our time: how will the unwind play out and what will be the consequences?
Finally, Goldman delivers a somewhat stark warning about the fifth cause of historical recessions: fiscal tightening. Multiple analysts are currently calling for the rest of the world to follow the US down the fiscal stimulus path in the new year and indeed, the assumption that ex-US government purse strings will be loosened just as the impulse from stimulus in the US fades is part and parcel of some folks’ “convergence”/ “recoupling” narratives.
But political tension and gridlock have the potential to muddy the waters, and Goldman cites the ongoing US shutdown as a case in point. On that note, we’ll leave you with one final passage from the bank’s piece, which is particularly germane this weekend.
This political dysfunction coupled with the increasingly unsustainable path of government finances raises the risk that fiscal policy will be less effective in combatting future downturns. The US has historically relied less on automatic stabilizers and more on discretionary countercyclical fiscal policy than most other advanced economies, making it more vulnerable to the possibility that party discord or a perceived lack of fiscal space could constrain fiscal stimulus in the future when needed.