It’s been a scary few weeks in the markets specifically and the economy generally. All the major indexes are heading lower. Key stock sectors (technology, consumer discretionary) are nearing bear market territory. We’re hearing and seeing more commentary about a potential recession. All this is happening right around the holidays — not exactly the best timing.
However, things really aren’t that bad. It seems scary because we’re in the middle of events. But when we pull the camera back, we see a fairly standard, end-of-the-economic cycle series of events. That doesn’t mean we shouldn’t be concerned. But it doesn’t [Had to add an n’t: BD] mean we should be screaming and running off a cliff.
So, let’s begin with THE key player: The Fed, which is currently raising rates. Why are they doing that? Because they’re supposed to right now. The Fed has a dual mandate: maximum employment and price stability. As for employment, we’re pretty much there, as shown in this chart from the Atlanta Federal Reserve:
The chart takes current data and compares it to the same data from a preceding period, allowing us to see “where we are” relative to key historical times. The gold line shows the latest labor market readings while the dark blue line shows the same data at the previous economic high point. With the exception of utilization and wages, the current labor market has surpassed previous highs, which is key for the Fed. In other words, we’re at “full employment.”
Then we have prices:
Above are the CPI and PCE price index shown in a Y/Y percentage change format. The former is used more often in the financial press while the latter is the Fed’s preferred inflation measure (see here for an explanation of the differences). The Fed has a 2% inflation target. CPI is running slightly hotter than that level while the PCE index is slightly below. But combine this data with the strong labor market, and an argument can be made that price pressures are building, which means the 2% level could start to increase at a faster pace in the near future.
Why doesn’t the Fed wait for that to happen instead of their standard course of acting pre-emptively? Because the Fed’s actions don’ t take immediate effect; it takes about 12-18 months for interest rates to work their way through the economy, which means the Fed has to act before inflationary pressures mount. Hence, their current course of action.
So, given the Fed’s mandate, they’re acting pretty rationally.
However, there has been some commentary that the Fed might be overtightening. There are several data points supporting this argument. The first is the yield curve, which continues to flatten:
Why is this important? Because a yield curve inversion has preceded every recession since the end of WWII:
What causes the inversion? At the short-end of the curve, it’s the Fed raising rates — which, again, they’re pretty much mandated to do at the end of an expansion. The long-end of the curve starts to “come in” because bond investors start to think growth will slow, which means less inflation, which makes longer-dated debt attractive. Hence, the inversion (bond prices and yields move inversely). Right now, it appears the Fed might be tightening into an inversion, which would give a potent recession signal.
Another argument against the Fed raising is that current rates are now above the “neutral interest rate” which means the Fed is “over-tightening.” What is the neutral rate? It’s a theoretical interest rate that is neither stimulative nor regressive in its level. Think of it as the “just right” interest rate. This level can’t be observed, but there are a few standard models. One is from the Richmond Fed:
The median level is about 1.5%, which means current levels are in the upper half of the theoretical range. Other models have different levels. However, these theoretical levels further bolster the argument that the Fed is raising too much.
A third argument against the Fed raising rates is that we’re already seeing pre-recession indicators. Here is a list of those:
- The Germany economy contracted in the third quarter
- The Japanese economy contracted in the third quarter
- China is slowing
- A hard-Brexit is looking like an increasing possibility
- The Markit Economics PMI indicators are softer (although still positive)
- Global equity markets are lower
- Oil prices are in a bear market
- CCC yields (junk bonds) are increasing
- Baa yields relative to their corresponding Treasury bonds are increasing
- Commercial paper relative to t-bills is increasing
- The yield curve is flattening
- 1-unit building permits are weakening,
- There’s a modest weakness in the housing market
- Auto sales have probably peaked for this cycle
- The stimulative effect of tax cuts is wearing off
- The stimulative effect of federal spending is wearing off
That’s a lot of data which we know typically leads the economic cycle (which is why we describe them as leading indicators). The Fed isn’t paying as much attention to the above data. They’re instead relying on their economic models, which are telling them to raise rates. However, it’s more than possible that the Fed will turn to a more data dependent decision-making process in the 1H19.
To sum up, we’re pretty much going through the standard “we’re at the end of an expansion” series of moves. The Fed sees an economy that they fear is going to run too hot, so they’re raising rates to pre-emptively stave off inflation. There is the possibility that they’ll “over-tighten.” We’re also starting to see standard signs of an economy that is slowing. BUT — there is no imminent economic crash headed our way. If we have a recession, it’s looking like it will be fairly shallow and short-lived.
I hope this helps to calm you down and enjoy the holidays.
This is a Creative Commons article. The original version of this article appeared here.