When Will the Next Recession Begin? Maybe Soon, Or Maybe Not

The U.S. could stumble into a recession relatively soon, or the economic expansion could last for years to come. The economy faces risks at the best of times, and forecasters surveyed in December on average saw the probability of a recession in the next 12 months at 14%. That means a downturn is seen as unlikely, but far from impossible. In the spirit of the two-handed economist, here are five reasons to worry that a recession might be coming—and five related reasons not to worry about it. WORRY: When the economy reaches full capacity, a recession usually follows within a couple of years. Economists think there’s a point at which the economy operates at top efficiency. Pushing output beyond that maximum sustainable level, known as potential output, can overheat the economy and produce damaging inflation. With a couple of exceptions, recent U.S. history has a recession begin within a few years of the output gap turning positive. And as of the third quarter, the output gap turned positive. DON’T WORRY: Our estimates for the economy’s full capacity might be wrong. Estimates of potential output are just that, estimates, and they can be wrong. Ahead of the 2007-09 recession, “these estimates were overly optimistic about potential output” and so “they typically said that the economy wasn’t running that far ahead of potential in 2007,” Federal Reserve Bank of San Francisco President John Williams told reporters in November. “In fact, now looking back, they tend to tell you that potential output was, in fact, lower, and that the economy was overreaching.” It’s possible the reverse is true today: Estimates for potential output may be too low and could eventually be revised higher, leaving the economy plenty of room to run. WORRY: The unemployment rate is low, and a labor shortage could generate out-of-control inflation. Low unemployment doesn’t sound like a bad thing, especially after a deep recession and slow recovery that saw the jobless rate reach 10%. At 4.1% in November, the unemployment rate held at its lowest level in 17 years—and below Federal Reserve estimates for its normal long-run level. Going below that threshold for too long could drive up labor costs as employers raise wages to compete for a shrinking pool of available workers, in turn pushing up prices. The Fed might respond to mounting inflation with aggressively higher interest rates, potentially driving the economy into a recession. That’s a scenario that Fed Chairwoman Janet Yellen has repeatedly cited over the last several years as a reason for the U.S. central bank to keep slowly raising short-term rates. DON’T WORRY: There’s not much evidence of mounting inflationary pressure. That may be the theory. But in practice, falling unemployment hasn’t generated much of a pickup in wage or price growth, at least not yet. That’s something of a mystery for the Fed, and one reason that officials have repeatedly lowered their estimates for how low unemployment can sustainably go. In fact, the Fed would like to see more inflation. Price growth has undershot the central bank’s 2% annual target for most of the last half-decade. And there are other upsides to a tight labor market. “I feel very pleased when I hear anecdotes from firms that tell me they’re having a hard time finding workers, and they talk about…taking on people with skills that don’t quite match what they want, but they’re training them, and, you know, giving them the training that they need in order to be able to fill jobs,” Ms. Yellen told reporters in December. WORRY: The Fed is raising interest rates, and tax cuts might make them go up faster. The Fed started raising short-term interest rates in late 2015 and plans to continue lifting rates over the next few years. Higher interest rates will slow economic activity, especially if they go up faster than financial markets expect. Some economists think the Republican tax overhaul signed into law in December will boost growth for the next few years and force the Fed to respond with a faster pace of rate increases. “Tax reform will accelerate tightening,” predicted Carl Tannenbaum, chief economist at Northern Trust. DON’T WORRY: The Fed is moving slowly and has signaled it doesn’t plan to counter tax cuts with sharp rate hikes. The Fed is moving slowly to raise rates because it doesn’t want to derail the expansion—“gradual” is the word that central-bank officials like to use. And officials signaled at their last meeting that they don’t plan to respond to the GOP tax law with a more aggressive pace of rate increases. Based on policy makers’ projections for stronger growth and lower unemployment, “that would perhaps push in the direction of slightly tighter monetary policy,” Ms. Yellen said. But, she added, “counterbalancing that is that inflation has run lower than we expect, and, you know, it could take a longer period of a very strong labor market in order to achieve the inflation objective.” WORRY: The yield curve is flattening. Financial markets can sometimes send signals about the future. The so-called yield curve, based on the gap between the yields for two-year and 10-year Treasury notes, is flattening. A flattening yield curve can be a warning sign because if the yield curve inverts—that is, if long-term yields fall below short-term yields—it usually means a recession is coming. DON’T WORRY: The yield curve hasn’t inverted, and this time might be different. That hasn’t happened yet and even if it does, that might not mean the expansion is doomed. “There is a strong correlation historically between yield-curve inversions and recessions, but let me emphasize that correlation is not causation,” Ms. Yellen said in December. She added that “there are good reasons to think that the relationship between the slope of the yield curve and the business cycle may have changed.” WORRY: The expansion has gone on so long that a recession might be overdue. In U.S. history, no economic expansion on record has lasted longer than 10 years. The current expansion already is the third-longest in history and while some forecasters think it could set a new longevity record, nothing lasts forever. DON’T WORRY: Expansions don’t die of old age. Economists like to say that expansions don’t die of old age, and San Francisco Fed researchers have found that the odds of a recession don’t seem to rise as an expansion ages. When it comes to the economy, maybe age is just a number. RELATED U.S. Economic Expansion Could Become Longest on Record (Dec. 13) Why Soaring Assets and Low Unemployment Mean It’s Time to Start Worrying (July 5) Many of 2016’s Recession Warning Signs Turned Out to Be Economic False Alarms (Dec. 28, 2016) Economists Believe a Recession Is Likely Within Next Four Years (Oct. 13, 2016) An Arbiter of Recessions Sees ‘Clouds on the Horizon’ for the U.S. Economy (June 20, 2016)

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