On the Brink of Recession

There doesn’t need to be a recession to tame inflation, but it looks as if there will be.

S taggering under the weight of bloated government spending and deficits, the U.S. economy has steadily weakened during the Biden administration. As shown in the chart below, growth slid from 12.5 percent for the four quarters ending in June 2021 to just 0.9 percent as of December 2022:

With this minimal growth, there is no safety margin to offset bad policy or bad luck in order to avoid a recession.

As evidenced by a long trail of incorrect predictions, forecasting a recession is one of the more difficult tasks in economics. One of the best indicators is a statistic called Real Final Sales to Private Domestic Purchasers, which measures total private-sector demand without distortions from sometimes-erratic inventory and foreign-trade statistics. As of December’s GDP, this statistic was on the brink of recession, illustrated below:

Only twice in the last 60 years has this statistic been as low as its December level of 0.0 percent without a recession.

Another good recession indicator, shown below, is manufacturing production, included in industrial-production data:

Manufacturing production has never been at its December 2022 level of decline without accompanying a recession, although it rallied for a couple of months before declining again in March.

Strong employment growth, shown below, is frequently cited as evidence that the U.S. is not nearing a recession:

While employment continues to grow at a good clip, there are several historical instances of employment growth at comparable rates immediately preceding a recession.

On balance, the above statistics on the real economy suggest a recession is looming, although it’s not yet apparent as of February data. The financial economy is another matter. As Ben Bernanke has observed, “since 1990 . . . financial disruptions have played an increasingly important role in economic downturns.”

A reliable precursor of recession is the shape of the yield curve, the range of bond yields for U.S.-government securities across the maturity spectrum from the short term to the long term. Normally, short-term bond yields are lower than long-term rates, which are riskier, but, when the reverse holds, it is an inverted yield curve which indicates recession. The following chart displays the difference between short-term, three-month Treasury bills and the extra yield between one- and two-year Treasury debt, each adjusted for the risk associated with its maturity or duration. (This is a similar concept to the yield spread the Fed follows most closely):

This yield spread has never approached its current level without a recession.

Increased interest rates that drove the yield-curve inversion have produced an enormous hit (at least on paper) to banks from lower market values for existing loans and bonds with fixed interest rates set at older, fixed levels. This is a formula for “financial disruption.” In mid March, the U.S. banking system reported assets of $23.2 trillion with a $2.2 trillion surplus value of assets over liabilities, or tangible equity net worth. An academic study has found $2.2 trillion of unrecognized impairment of banking-system assets, leaving market-value bank equity effectively worthless for the system as a whole. In comparison, as of December 2022, Silicon Valley Bank had market-value equity of 0.5 percent of assets. In the 1998 demise of hedge fund Long-Term Capital, equity was reported as 0.4 percent of assets.

So, with prior examples of failed banks and hedge funds running leverage comparable to the entire U.S. banking system now, how does this end well? Historical instances when banking systems lost their equity value include Japan — with a long, steady squeeze on lending and the economy — and the U.S. in the 1980s and the great financial crisis which required sharply lower rates and recapitalization.

While exceptions exist, taken as a whole, the entire U.S. banking system has minimal net worth at market values. Who would want to lend to or deposit uninsured money from it? In fact, declines in deposits and loans to the banking system characterize recessions, as shown in the chart below:

Every recession in the last 50 years has seen declining deposits and loans to finance bank-credit growth. In the last year, deposits have shrunk by $840 billion. Loans have increased $616 billion from the private sector, with the Fed lending an additional $285 billion to prevent banking-system shrinkage. Any decline in the banking system’s borrowing and lending would likely signal a recession’s onset.

To boost banking solvency, it is necessary to lower rates, a dilemma for the Fed which is still dealing with high inflation figures. Examined more closely though, a very strong case can be made that this dilemma has passed. In the last five months, since the collapse of housing prices and rents beginning in August 2022, adjusted to current market housing prices instead of the one-year lag in official data, the Fed’s preferred core PCE inflation measure comes in at 2.5 percent as compared with 5.9 percent in the five previous months. In less than a year, inflation has gone from rapidly accelerating to rapidly decelerating based upon current market housing prices.

This is not without precedent. The chart below depicts the adjustment to inflation based upon current housing costs versus the lagging official statistics:

(Due to data availability, the chart uses purchase costs instead of rental costs as in official data, but purchase and rental costs track consistently over the medium term.)

The pandemic-era pattern of market housing costs first escalating well above official inflation and then well below it is a compressed replay of the run-up to the Great Financial Crisis. The Fed spent a year from July 2006 to July 2007 holding fed funds steady at 5.25 percent (near its currently expected peak rate.) Belying that seeming stability, the collapse of housing prices meant the rate became extremely restrictive, which the Fed only belatedly recognized.

To avoid repeating that dismal scenario, the Fed should heed the market, which is pricing in future rate cuts. Congress would be well advised to reverse the stagnation evident in this article’s first chart and freeze domestic spending, which has grown a staggering 42 percent since before the pandemic.

There doesn’t need to be a recession to tame inflation, but it looks as if there will be.