The ‘Unpleasant’ Specter Of Economic Decline

There’s no such thing as a “good” recession. Only less bad ones.

If you have to have a recession — and quite a few observers are convinced the US needs one desperately to cool inflation — it’s best if it’s not triggered by a systemic event.

I’ve persisted in a kind of self-imposed limbo for the past six years, but even prior to that, life felt a lot like purgatory. My last genuine memories — visceral moments my mind recognizes as unequivocally “real” — are from 2010. To me, Lehman “feels like yesterday,” and I don’t mean that in the clichéd sense that we often employ the phrase. I still think it’s vaguely possible I’ll wake up one day in 2009 and think, of the past dozen years, “What an odd dream.”

For the countless twenty- and, I guess, thirty- somethings on Wall Street who weren’t attuned to the scope of the calamity at the time, the prospect that every major bank might fail and that financial services, in general, might cease to exist or revert to some pre-modern state, was disconcerting, to put it mildly.

From the archive: Where Were You When The World Didn’t End?

In 2022, there’s no systemic event, and with the caveat that systemic events tend to blindside everyone, it’s not immediately obvious what would constitute such an event right now. I’m sure sundry financial tabloids can give you a laundry list of potential systemic risks, but with apologies to the folks who run those portals, those lists haven’t changed in decades, and the fact that, as far as I’m aware, none of them included “imminent collapse of US mortgage market” in 2006 speaks to their usefulness.

Assuming a recession is coming this year or next, and assuming it won’t be accompanied or triggered by a systemic event, what would it look like? That’s the question Goldman asked in a new note that also found the bank suggesting the odds of a US downturn over the next 12 months have increased materially.

“The two best predictors of more severe recessions [in advanced economies] are financial crises and initial economic overheating,” the bank said. They’re not worried about the former in the current conjuncture. As for the latter, the bank’s David Mericle and Ronnie Walker wrote that the overheating risk “largely reflects the hesitancy of policymakers to ease when still coping with an inflation problem that persists into a recession.”

That’s the risk facing developed economies in 2022. Central banks risk triggering recessions with draconian rate hikes to contain inflation, but given the starting point for rates (i.e., the lower-bound), it’s unlikely they’ll be able to free up enough breathing room to deliver substantial easing if they do, in fact, cause a recession.

“Wage growth and inflation would fall quickly in a recession because we are doubtful that high inflation expectations are sufficiently entrenched to sustain high inflation amidst rising slack,” Goldman wrote. If true, ebbing inflation would give the Fed scope to cut rates, but as Mericle and Walker went on to say, “the Fed is unlikely to have room to deliver the over 500bps of cuts it has in an average recession.” Even if the Fed hikes rates to 5% (a level virtually guaranteed to trigger a recession and well above the highest terminal rate projections), delivering the “standard” dose of easing to combat the ensuing downturn would mean cutting rates back to zero.

Worse, the political circumstances in the US are likely to be such that fiscal policy will be no help. “The fiscal response would be even more limited because the US is likely to have divided government after the upcoming midterm elections,” Goldman remarked. That’s just irony atop irony: If Republicans do, in fact, manage a good showing in November, it’ll be at least partly due to voter discontent with the economy, which will only get worse if divided government hinders fiscal policy. An inadequate response from lawmakers would only increase public disaffection and pile still more pressure on monetary policy.

“Our best guess is that a recession caused by moderate over-tightening would be shallow, though we could imagine it dragging on for a little longer than it would with more policy support,” Goldman said. The figure (below) shows that, on average, shallow recessions found GDP growth bottoming 3.75 percentage points below potential, with a 2.5 percentage point increase in the unemployment rate.

There’s very little difference in default rates and equity performance in deep versus shallow recessions, although I’d note that if you looked at 2008 in isolation, it’d stick out.

In any event, Goldman now sees the odds of a recession engendered by over-tightening as considerably higher versus just a few weeks ago. Assuming the scope of the over-tightening is “moderate,” the recession is likely to count as the fourth “shallow” downturn in the post-War era.

But, coming full circle, no recession is a good recession. As Mericle and Walker put it, “even shallower recessions have been unpleasant.”