Inevitably, Bill Dudley’s “inevitable” recession call prompted pushback from some market participants and served as an excuse for analysts to deploy various models in an effort to determine if, in fact, an economic downturn in the US is now a foregone conclusion.
Earlier this week, in an Op-Ed for Bloomberg, Dudley blamed the Fed for inflation and suggested a soft landing is all but impossible. It wasn’t a wholesale indictment of flexible average inflation targeting (AIT). Rather, it was an indictment of the Fed’s application of the strategy.
Dudley argued that the Committee’s commitment to achieving full employment and ensuring the durability of inflation before tightening policy meant the Fed was destined to find itself behind the curve, and would end up forced to push the unemployment rate higher, triggering the Sahm rule which, on a simple interpretation, is infallible.
Read more: As 2s10s Inverts, Dudley Says US Recession ‘Inevitable’
In a new note, Goldman alluded to Dudley without mentioning his name. “There has been commentary on the ‘inevitability’ of recession and a hard Fed landing with inflation so far above target and the labor market very tight,” the bank’s Vickie Chang wrote, linking to the Op-Ed penned by Dudley.
The Goldman-government-pundit nexus means irony is a fixture of these sorts of debates. Dudley was, of course, Goldman’s chief US economist for a decade.
Chang attempted to extract the recession signal embedded across assets and time in order to “back out the recession probability and timing that assets are pricing.” The sample begins in 1970-73 and excludes 2020. It captures six or seven recessions, depending on the asset. Only dates when the economy wasn’t currently in recession were counted — Goldman wanted to determine the odds of the economy falling into a recession, after all.
Not surprisingly, Chang found that “yield curves do a better job of predicting recessions overall… irrespective of the curve segment.” There’s quite a bit of ambiguity around the timing, though. The table (below) shows just one indicator currently suggests a recession is anything like “inevitable.”
There are anomalies everywhere you turn. “This time is never different,” as Harley Bassman is fond of insisting, but this time is different at least to the extent the accelerated nature of the cycle has seemingly scrambled some signals.
For example, Chang pointed out the stark divergence between the probabilities implied by the three-month versus instantaneous two-year rate (i.e., no chance of recession over the next year and very low odds of a downturn over two years), and those implied by the instantaneous two-year versus five-year forward rate (Dudley-esque odds over two years).
“Both segments are, historically, relatively good predictors of recession when considered individually, so this unusually sharp divergence in the probabilities implied by different parts of the curve is another indicator of the unusual structure of the current yield curve,” Chang wrote, noting that when the indicators are rolled up into a single model, the 2y5y forward curve is overwhelmed. Suffice to say the only indicator consistent with an “inevitable” recession didn’t make it into Chang’s final model.
The figures (below) show markets aren’t currently pricing a recession as a foregone conclusion. Far from it. There’s almost no chance of a recession over the next 12 months. Further out, the risk is more elevated, but as Chang ventured, “the 38% chance that the model assigns to a recession in the following year is well below ‘inevitable.'”
Do note, (and Chang mentioned this) that the odds depicted in the figure on the right (above) are nevertheless double the unconditioned probability.
Naturally, Goldman added a number of caveats. The model is based on asset prices/levels, not economic fundamentals. You can look at that two ways. It’d be easy to suggest that because we’re talking, in the final analysis, about the economy, a model that doesn’t include economic variables might not be the best model. On the other hand, the whole debate centers around the yield curve in the first place, so that criticism is an exercise in question-begging: Either market signals matter, or they don’t. We assume they do. So, Chang took a closer look.
Ultimately, Goldman’s assessment is benign. Although the bank’s econ team “see[s] the risk of a US recession this year as higher relative to an average year, a recession if it were to occur would probably be mild by historical standards as the economy lacks major financial imbalances that would exacerbate a slowdown,” Chang said.
https://www.denverpost.com/2008/01/09/goldman-sachs-forecasts-recession-in-2008/amp/
https://www.federalreservehistory.org/essays/great-recession-of-200709
Just thought some history could be helpful. Essentially, economists are bad at predicting recessions until we’re in one. Let’s piece things together, in Dec 2007, the recession that led to the GFC started. In Jan 2008, economists didn’t know we were in a recession, but started to forecast that a recession was 40% probable. Markets didn’t know/reflect we were in a recession until the Lehman Brothers bankruptcy in Sept 2008.
Lets confess that if you are Goldman, there are incentives to downplay recession, but if you are ex-NY Fed you are free to speak the truth. It sounds so obvious that it actually is embarrassing to write it here.
Things are changing so fast- we are going to have a truncated cycle this time is my outlook. What is that worth- not much. I have an itchy trigger finger to reduce equity allocations for my clients. It boils down to risk management and risk adjusted return. It may not be the right move but if I do it I will not second guess myself.
This comment from Kevin Warsh from about a year ago is interesting and in hindsight he probably would have provided better leadership at the Fed, but, trump picked Powell instead and here we are with QE rolling on like the Columbia river.
“The longer they wait, the more expensive it will be. The bigger shock it’ll be to markets, the bigger risk that it’ll be to the real side of the economy.
“My guess is we’re going to see increases both in volatility, as well as in the volatility of volatility, as we’re racing through the next 12 months with a series of facts that we can only hypothesise now.
“But if I look broadly across assets, I would say our governments have been trying to bid up asset prices for most of the last dozen years, especially over the last 12 months or so.”
What seems obviously ridiculous in retrospect is that the pandemic recession started and ended in 3 months, in terms of how that was measured.
If there were ever any doubts that economic measurement techniques were broken or manipulated, that quantum fast crisis fix is absolutely absurd. Regardless of that stupidity, it set the stage for the naive chit chat of inflation being transitory and the illusionary belief that the V-recovery was not a distorted anomaly.
As the Fed bought into their excellent policy execution and buried their collective heads as far as possible into the sand, they instead focused on which ties to wear, what tint of makeup to wear and which noncommittal words to use to defend themselves.
Apparently, sometime after the recession was over in June 2020, thought must have been given to unwinding stimulus, especially for banks or large entities that may not have needed full life support?
It’s possible that the Fed, during mid 2020 was simply going about fulfilling statutory obligations connected to the Cares Act, and as with TARP before it, they were doing as congress mandated?
Nonetheless, within all the bureaucratic politically poisoning interlaced in these messes, it should have been obvious that inflation was being swept under the rug. That was a process and choice and it was deception and it was mismanaged if not corrupt. It was criminal to not plan ahead for where we are today.
Getting technical, historical measures that use 3 mo yield are suspect because in prior pre-recession periods, Fed was not holding FF and thus 3 mo at or near ZLB.
More broadly, look at how quickly Goldman’s model goes from very low probability of recession to very high probability. It sits at very low for years, then goes near-vertical to very high in a very short time. It’s almost binary. It would be interesting to see: when the model flips from “nothing to worry about” to “be very worried now”, has the market already rolled, or is the roll to come?
At the end of the day, we’re (ok, some of us) not actually interested in forecasting recessions, we’re interested in forecasting the bear markets that typically begin before the recessions are apparent.
The concept that the Fed has around 900 super smart economic gurus, who all missed the inflation possibilities, had me think this is another example of monkeys at keyboards.
From a Wikipedia scan, this comes up:
“For Jorge J. E. Gracia, the question of the identity of texts leads to a different question, that of author. If a monkey is capable of typing Hamlet, despite having no intention of meaning and therefore disqualifying itself as an author, then it appears that texts do not require authors. Possible solutions include saying that whoever finds the text and identifies it as Hamlet is the author; or that Shakespeare is the author, the monkey his agent, and the finder merely a user of the text.”