IS THE US ALREADY IN A RECESSION?! PLUS SOME PRELIMINARY THOUGHTS ABOUT (1) THE YIELD CURVE IN LIGHT OF RECENT REAL GDP DATA AND (2) WHAT TO DO IF THE US IS IN A RECESSION

 

The initial estimated release yesterday (Thursday, April 28) morning for US real GDP during the first quarter of 2022 from the US Bureau of Economic Analysis (BEA) clearly causes us to consider a question – is the United States already in a recession?  Readers can find the Full Release and Table by visiting the following website below and then clicking on Related Materials and then clicking on Full Release & Table.

https://www.bea.gov/news/2022/gross-domestic-product-first-quarter-2022-advance-estimate 

Showing an estimated annualized decrease of approximately 1.4 per cent last quarter, the US BEA estimated that on a seasonally adjusted basis, the US economy produced a smaller sum of goods and services in the first quarter of 2022 than in the fourth quarter of 2021.  Seasonal adjustments such as the ones used by the US BEA could be especially appropriate given that production in the first quarter of a new year almost always (if not always) decreases compared with the fourth quarter of the previous year due to winter holiday shopping spurring greater economic activity in the fourth quarter.

A textbook-style definition for a recession often if not usually or always states that a recession has at least two quarters of contraction (meaning negative real GDP growth) near each other.  Textbook definitions may require that two quarters of decreasing real GDP growth need to be consecutive in order for a recession to occur.  The National Bureau of Economic Research (NBER) does not require consecutive quarters of contraction in determining a recession, and it also monitors other factors such as employment in deciding whether recessions have occurred, and if so, the duration of recessions.  For example, the website of the NBER (https://www.nber.org/research/data/us-business-cycle-expansions-and-contractions) lists a recession occurring in the US in most of the year 2001, but data from the US BEA and accessed from the FRED website of the Saint Louis Federal Reserve Bank (https://fred.stlouisfed.org/data/A191RL1Q225SBEA.txt) show that US real GDP fell in the first and third quarters of 2001 but not in the second quarter (or the fourth quarter) of that year.

Given that the initial estimate for US real GDP may be revised, we cannot be certain that the ultimate estimate for US real GDP will show contraction in the most recently completed quarter.  However, this initial estimate with a decline in real GDP could be an indication that another US recession may have already begun.

Readers of my previous blog post (available at https://harrisonhartman.blogspot.com/2022/04/what-do-yield-curve-and-some-other.html) will likely expect that I am very surprised by this estimate of a decrease in economic activity in the US in the first quarter of 2022.  The 1-to-10 year interest rate US Treasury yield curve, the yield curve that Bauer and Mertens (2018) at least implied if they did not outright state was the best one to monitor for recessions coming in the near future, has still not inverted, with an inversion in that yield curve (where the 1 year US Treasury debt interest rate would be higher than a 10-year US Treasury debt interest rate) still not close to occurring.  Some watch the 2-to-10-year yield curve instead of the 1-to-10 year yield curve.  Although this yield curve inverted, the inversion was very brief and based on data from the FRED website of the Saint Louis Federal Reserve Bank (available at https://fred.stlouisfed.org/series/T10Y2Y), it did not invert until April 1, 2022, the day after the first quarter ended.  The 5-to-10-year US Treasury interest rate yield curve inverted earlier, but not much earlier.  This 5-to-10-year yield curve inverted in or around late March 2022 (if my memory is correct), near the end of the quarter.  So what happened or did not happen to the yield curve? If the US is currently in a recession, then why didn’t yield curves invert no later than the fourth quarter of 2021 so that they would still have forecasting ability regarding recessions by inverting before a recession occurs?

While real GDP decreased in the first quarter of 2022, nominal GDP increased. Nominal GDP measures the production of goods and services at current prices to give an aggregate measure of economic activity.  This is done to assign values to the production of diverse goods and services such as toothpicks, hospitals, and education; where the values can be summed into one aggregated number.  One purpose of real GDP is to compare production at two different points in time after prices may have changed.  The US BEA estimated that the price index for gross domestic purchases (as a measure of the price level) increased last quarter at a seasonally adjusted annualized rate of around eight per cent.  Thus, on average, one US dollar bought fewer goods in the first quarter of 2022 than in the fourth quarter of 2021.  Surging gasoline prices and other cost increases have contributed to a sharp increase in the rate of inflation in the US in recent quarters.  The US BEA estimated that nominal GDP, meaning total GDP spending in dollars with the buying power of a dollar in the first quarter of 2022, actually rose by about 6.5 per cent, but prices rose so rapidly that the actual production of goods and services in total fell in that quarter.  At least some consider this to be a sign of a negative aggregate supply shock because nominal GDP rose but real GDP decreased.

Data from the FRED website of the Saint Louis Fed (https://fred.stlouisfed.org/data/M1V.txt) show that the velocity of the US M1 money supply fell in the first quarter of 2022, albeit slightly.  This continues a downward trend of longer than a decade in US M1 velocity despite a brief increase in the fourth quarter of last year.  Data available at https://fred.stlouisfed.org/data/M2V.txt also from FRED of the Saint Louis Fed show rather similar behavior in US M2 velocity (although M2 velocity peaked in 1997, about a decade before the M1 velocity peak).  Will inflation pressure in the US continue if US M1 and M2 velocities continue to trend downward, despite a temporary increase in the fourth quarter of last year?

Much of the decrease in US real GDP last quarter occurred due to decreases in government purchases and net exports, as consumption and investment overall increased last quarter on a seasonally adjusted, annualized basis.  Regarding government purchases last quarter, both (a) US federal and (b) state and local government purchases in the US decreased, but the percentage decrease in federal spending was larger.  Further, both military and non-military spending decreased, but the percentage decline in military spending was greater.

Returning to a question posed earlier, I can think of at least five possible explanations as to why the yield curve did not invert sooner, for example, in the year 2021.  Perhaps the yield curve would have inverted had the Federal Open Market Committee (FOMC) raised its target for the federal funds rate sooner when unemployment rates returned to relatively low values.  This explanation may possibly suggest that the ability of the yield curve to predict imminent recessions is contingent upon the FOMC raising interest rates either when unemployment rates fall to certain values or when real GDP reaches certain levels and that the US is already past those points.  A second explanation is that the predictive power of the yield curve works in forecasting decreases in consumption spending by households and/or investment spending by firms but not government purchases or net exports.  Because consumption and investment on the whole remained relatively strong in the US in the first quarter of 2021, at least to this point the yield curve would not have been able to predict the decreases in government purchases or net exports if it can only forecast decreases in consumption or investment in physical capital or both consumption and investment.  A third possible explanation is that a structural break has occurred and that the relationship between a yield curve inversion and a future recession has changed, possibly to the point of such a relationship no longer existing.  It is not clear whether the inversion of the yield curve caused previous recessions or if it was a symptom of one or more other factors that caused a recession or both.  But in this third explanation, the causal relationship whatever it was has changed and may have even broken.  A fourth possible explanation, perhaps a subpart of the third explanation, has the slope of the yield curve depending on decisions of the FOMC and financial market participants, with at least some financial market participants making debt instrument decisions based on expectations of a recession.  Regarding this fourth explanation, the yield curve inverted before past recessions because financial market participants expected a recession coming and bought and sold US Treasury debt instruments in such a way as to invert the yield curve.  However, in 2021 and early 2022, few if any US Treasury debt market participants expected a recession and so the yield curve did not invert, even though in this fourth explanation a US recession is imminent if not already underway.  A fifth and final explanation is that a recession is not currently occurring in the US and is not coming soon, and the decrease in real GDP last quarter turns out to be extremely short lived.  As implied if not outright stated above, some overlap in explanations exists.  I am not sure which explanation or explanations is or are correct.

I saw CNBC’s Sara Eisen interviewing Heather Boushey of the Council of Economic Advisors on CNBC yesterday afternoon.  If I remember correctly, then one of the things that they discussed was that the strong US dollar and economic problems around the world probably had a large impact on US net exports last quarter.  All other things equal, when the US dollar appreciates relative to other currencies, people in the US buy more imported items (where the production of those items not including distribution costs within US borders does not count toward US GDP) and people in other countries buy fewer US exports.  I think that Boushey and Eisen both agreed that consumption and business investment in the US were strong last quarter.  I seem to recall that Boushey’s view was that last quarter’s consumption and investment data were good indicators of future economic activity.  For completeness, readers may want to realize that both US consumption of nondurable goods and US business investment in nonresidential structures decreased last quarter, although total US consumption and total US investment in physical capital were estimated to have increased (at a seasonally adjusted, annualized rate) between 2 per cent and 3 per cent last quarter.  (Business investment in physical capital may also have decreased last quarter.)

Toward the end of the interview, Eisen and Boushey noted that the Federal Open Market Committee (FOMC) of the Federal Reserve will need to decide soon on what to do with interest rate targets.  Boushey declined to comment on Federal Reserve policy but said (if I recall correctly) that the Fed would likely consider the estimated decrease in US real GDP in its policy deliberations.

Although the Council of Economic Advisors and the Presidential Administration may have a policy of not commenting on Fed decisions, that constraint does not apply to many people like me.  How rapidly, if at all, can the Fed raise interest rates if the US economy has already started to contract?  If US inflation is already peaking (although it may be much too early to know for certain whether US inflation is at a local maximum), then would it even be necessary for the Fed to continue tightening monetary policy by raising interest rates?

What about fiscal policy?  If Congress and the President have the will, then they can be more aggressive in trying to stimulate economic growth.  It may be time again for tax reductions and increases in government spending, particularly when total government purchases in real terms have decreased three out of the last four quarters and real federal government purchases fell all four of those quarters, if I remember the table from the US BEA correctly.  Measures to reduce economic inequality could be particularly helpful because those not among the most affluent are more likely to spend a greater percentage of their additional income than those who have been more fortunate in the past.

Readers should realize that much of the blog post above is based on estimated data.  Subsequent revisions could change the analysis.

REFERENCE

Bauer, M. D. and Mertens, T. M. (2018). "Economic Forecasts with the Yield Curve." March 5, 2018. FRBSF Economic Letter. 2018-07. Available online at:  https://www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve/ 

 

WHAT DO THE YIELD CURVE AND SOME OTHER FACTORS TELL US ABOUT THE POSSIBILITY OF A U.S. RECESSION COMING SOON?

 

Will the U.S. have a recession soon?  At this point, while it is possible, I think that it’s difficult to conclude with a high degree of confidence that the U.S. will soon have a recession. Based on information to follow, we may question whether recent U.S. yield curve behavior is signaling a recession in the near future.

It is well known that changes in the slope of the U.S. Treasury yield curve, which is the difference between a longer-term interest rate and a shorter-term interest rate (perhaps for the same borrower), have foretold U.S. recessions in the past.  Normally, longer-term interest rates are higher than shorter-term rates, perhaps because lenders require a premium for lending their funds for a longer period.  All else the same, the longer the term to maturity, the higher is the interest rate for the loan.  However, when shorter-term interest rates on U.S. Treasury debt have exceeded longer-term interest rates, such inversions have often been associated with a U.S. recession on the horizon.  The thinking is that an inverted yield curve implies that people expect lower interest rates in the future (due to expectations of lower real GDP growth, lower inflation, and/or higher money supply growth), to the point that these expectations dominate the liquidity premium and result in a yield curve that is at least partially downward sloping where a longer term to maturity is associated with a lower interest rate for the downward-sloping part of the yield curve.

Many have been trumpeting the inversion of the yield curve using the two-year interest rate and the ten-year interest rate of U.S. Treasury debt as foreshadowing a recession coming in the U.S.  If I remember correctly, then some even pointed to the recent inversion of the five-year and ten-year U.S. Treasury yield curve as foretelling a recession.

However, I think that the certainty of a U.S. recession in the very near future is ambiguous at best for at least two reasons.  First, the aforementioned two-to-ten-year and five-to-ten-year yield curves were no longer inverted based on data that I saw recently on CNBC.  I am not certain that very short-term inversions of the yield curve have accurately forecasted recessions in the past.

Second, Bauer and Mertens (2018), perhaps using monthly interest rate data, note the high degree of forecasting accuracy of recessions in the U.S. when the ONE-to-ten-year U.S. Treasury yield curve inverts.  My memory seems to tell me that their work found that (a) the one-to-ten-year yield curve for U.S. Treasury debt inverted less than twenty-five months before ALL U.S. recessions in recent decades up to the time of their study, and (b) the one-to-ten-year yield curve produced a ‘false positive’ result (where the yield curve inverted but no recession ensued within two years in the U.S.) only once during their sample period.  The ONE-TO-TEN-YEAR U.S. Treasury yield curve has NOT COME EVEN CLOSE TO INVERTING this year and has probably not come close to inverting since soon after the periods in which it was inverted in 2019.  Readers may want to note that a U.S. recession started in early 2020, which obviously is less than two years after the 2019 inversion of the U.S. Treasury one-to-ten-year yield curve.

Given that (1) recessions have periods of decreasing real gross domestic product (real GDP) and (2) real GDP is comprised of real consumption (by households), real investment in physical capital (largely if not completely by firms), real government purchases (by various domestic government sectors), and real net exports (or exports minus imports, both measured in ‘real’ or constant-buying-power currency); a U.S. recession must have AT LEAST ONE of the following:  decreasing U.S. consumption, decreasing U.S. investment, decreasing U.S. government purchases (including state and local government purchases in the U.S.), or decreasing U.S. net exports.  U.S. retail sales have been strong at least until recently based on reports from the U.S. Census Bureau.  If U.S. consumption continues to increase due to (a) the stimulus efforts that were implemented and (b) pent up demand following the COVID-19 shutdowns, then a recession would need to be due to a decrease in investment in physical capital by firms, decreases in government purchases by the government sectors, and/or a decrease in net exports, and the decrease or the decreases must be sufficiently large to offset the increase in consumption spending (and other increases that may occur).

Does the failure of the ONE-TO-TEN-YEAR U.S. Treasury yield curve to invert thus far in the year 2022 indicate that bond market participants are forecasting continued growth in the sum of U.S. consumption spending, U.S. investment in physical capital, U.S. government purchases, and U.S. net exports?  Does this mean that the U.S. economy is not headed for a recession within the next two years?  To the extent that the findings of Bauer and Mertens (2018) hold, a U.S. recession in the short term becomes much more likely if the one-to-ten-year U.S. Treasury yield curve inverts.

Of course, a negative aggregate supply shock such as the recent surge in oil and gasoline prices could lead to a recession.  Readers may remember that the U.S. experienced recessions in the middle of the 1970s and the early 1980s around the times of energy crises.  If my memory is correct, then with the goal of reducing inflation, the Fed tightened monetary policy before both of those recessions, and the one-to-ten-year U.S. Treasury yield curve inverted before both of those recessions.

The Federal Open Market Committee (FOMC) of the Federal Reserve Bank has already begun raising interest rate targets with the goal of reducing inflation as inflation has dramatically increased recently in the U.S.  If the Fed raises shorter term rates substantially and longer term rates do not increase sufficiently, then that could cause the one-to-ten-year U.S. Treasury yield curve to invert, which Bauer and Mertens (2018) may interpret as a clear signal for a recession.  But, if Bauer and Mertens’ (2018) finding (or suggestion or conclusion) that the one-to-ten-year U.S. Treasury yield curve is really the one to watch, then at this point the yield curve has not yet signaled a recession coming in the U.S. within the next two years (if not longer).  Will further tightening by the FOMC, removal of expansionary fiscal policy, changes in the supplies of and the demands for U.S. Treasury debt instruments, a decrease in businesses’ and households’ desires to spend, other factors, or some combination wind up resulting in (a) an inverted one-to-ten-year U.S. Treasury yield curve and (b) subsequently a U.S. recession?  Is the one-to-ten-year U.S. Treasury yield curve really the one to watch?  Vigilant eyes cast on the one-to-ten-year U.S. Treasury yield curve, other yield curves, and other data will find out in time.

 

REFERENCE

Bauer, M. D. and Mertens, T. M. (2018). "Economic Forecasts with the Yield Curve." March 5, 2018. FRBSF Economic Letter. 2018-07. Available online at:  https://www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve/ 

JUNE 21, 2022 ADDENDUM

I noticed today on CNBC that the five-to-ten-year U.S. Treasury yield curve was reinverted.  I do not know when that yield curve reinverted.  Please accept my apology for any inconvenience or confusion.  

However, if the one-to-ten-year U.S. Treasury yield curve is the most reliable in predicting upcoming U.S. recessions, the main message of this blog post remains unchanged.  We can continue monitoring data to improve our perception of the direction of the U.S. economy.