Learning from a Century of US Recessions
The article below is from our BRIEFINGS newsletter of 04 February 2019
The realities of growth deceleration, higher rates, and significantly tighter financial conditions have markets on heightened recession watch. But recession risks look modest according to GS Research economists Jan Hatzius and David Mericle, whose study of 100 years of US recessions suggests the prospects for a “soft landing” are better than widely thought.
Jan, your read on recession risk remains more positive than markets. How would you sum up your reasoning?
Jan Hatzius: It comes down to understanding the factors that have moved the needle on recession risk historically, and feeling that we’ve seen sufficient policy and structural changes in those areas to make the economy less recession-prone. David and I just wrapped up a study of the last century of recessions in the US, and we found that they can be boiled down to five major causes: industrial shocks, oil supply shocks, inflationary overheating followed by aggressive Fed tightening, private sector financial imbalances, and fiscal tightening. We’d argue that several of these “usual suspects” have become structurally less threatening over the last 30 years, and the financial risks that are still important triggers today are not flashing red as they did before the 2007 crisis.
Which triggers look less relevant today?
David Mericle: The first three Jan mentioned—industrial shocks, oil supply shocks, and inflationary overheating. The reality is that the most cyclical industries now comprise a much smaller share of US GDP than they once did, and modern technology and supply chain management techniques have greatly reduced the inventory cycles and production volatility that used to weigh heavily on the economy. There’s a similar story playing out in oil. US energy intensity as a share of GDP has declined, and the growth of the US shale industry means that price shocks now have a more balanced effect on US GDP, lowering consumption but boosting energy investment. But the most important structural change in our view is the shift we’ve seen in inflation dynamics. Inflation has become less sensitive to labor market slack, and inflation expectations have become better anchored on the Fed’s target. As a result, inflation now rises more modestly in response to falling unemployment, and doesn’t accelerate the way it did in the 1960s and 1970s. This allows the Fed to be more patient—they don’t have to counter today’s unemployment lows with aggressive hikes to ward off an inflation spike. Instead they can be more measured with normalization and take into account softer growth data, as we saw last week.
Could fiscal policy cause a recession?
Jan Hatzius: When you look at the recessions where fiscal tightening played a contributing role, they’ve coincided with major post-war demobilizations and spending pullbacks on a scale we haven’t seen since the Korean War. That said, with rising political polarization and uncertainty, broader fiscal policy could evolve into a risk that at the very least makes a future recession worse. By the time the next downturn rolls around, political dysfunction coupled with years of rising deficits might make fiscal policy less effective in spurring economic recovery.
Of the historical causes, that leaves private sector financial imbalances. Are you seeing shades of 2007 here in terms of households or corporates spending beyond their means?
David Mericle: No—in fact the private sector is actually running a financial surplus, and to a degree that’s unusually benign this deep into an expansion. This is a sharp contrast with conditions before the last two recessions, and it’s comforting because the private sector financial balance has been a very good predictor of financial crises. So while we don’t think financial risk has declined over time—if anything, financial globalization could present new risks—at the moment we’re not overly worried about financial stability from a recession risk standpoint.
So what recession forecast do you come away with?
Jan Hatzius: We think current concerns about recession risk are overdone, and the prospects for a soft landing are better than widely thought. While new risks could emerge, none of the main sources of recent recessions—oil shocks, inflationary overheating, and financial imbalances—seem too concerning for now.