The Fed Has Done Much to Delay the Next Recession


(Bloomberg Opinion) -- There is one very important rule that all market participants should keep at the forefront of their minds: The Federal Reserve wants to kill your recession call.

That rule came to mind when I saw this comment from David Rosenberg, the chief economist of Gluskin Sheff + Associates:

“I love to read the bloggers out there who say ‘a slowdown isn’t a recession.’ Someone should remind them of Newton’s laws of motion. A slowdown doesn’t morph into a recession when there is some exogenous (positive) shock that turns the tide. And when it isn’t about the Fed easing policy, then it is another Central Bank, like the ECB and BOJ in 2016.”

This is, for the most part, correct. I would qualify the assertion as “the probability that a slowdown turns into recession decreases if the Fed promptly eases policy.” A recession typically occurs when the Fed over-tightens monetary policy or fails to ease quickly when the economy faces a negative shock. My general rule of thumb is that if the Fed fails to cut rates after the spread between yields on two- and 10-year Treasuries inverts, there is a high probability of recession in the next 12 to 24 months. Prior to the last two recessions, the Fed made what I believe to be a cardinal sin of central banking, actually hiking rates after the yield curve inverted.

What does this have to do with the current situation? It is important to recognize that the Fed has already eased policy. In other words, they have already delivered a positive shock. Even more importantly, they delivered this shock before the data deteriorated substantially. Compared to past cycles, this is a fairly early move on the part of central bankers. In fact, as recently as last month the 12-month pace of job growth was still accelerating and yet the Fed made a substantial dovish shift.

But you might say that the Fed didn’t cut rates. True, but it did the next best thing. By shifting into “patient” mode, the Fed lowered the expected future path of short-term rates, dragging down the yield curve as a result. I expect the Fed will make this shift explicit in the next Summary of Economic Projections at the next policy meeting in three weeks with a dot-plot that suggests most policy makers expect no or at most one rate hike in 2019. This compares with a median forecast of three rate hikes back in September.

This shift in the expected path of was undoubtedly a positive shock. Bond yields have not risen much from their year-end decline whereas stock prices have recovered from the December selloff. The Fed’s actions already appear to have disrupted the pessimism that was building in financial markets and arguably the overall economy as well. For instance, consumer confidence rebounded in February after stumbling in January.

Also note that the Fed stands ready to cut rates if needed, although policy makers do not see this as the most likely path. But the lack of any evident inflation concerns means that the bar to a rate cut is fairly low. Should the outlook darken further, the Fed will act. Finally, recall that this isn’t the first time the Fed has suddenly shifted to a dovish stance. The Fed did something fairly similar in early 2016 by pulling back expectations for four rate hikes that year and, in the process, short-circuiting the slowdown at the time and rendering recession calls null and void.

To be sure, none of the above conclusively rules out a recession nor can it prevent the data from revealing some softness. The weak December retail sales report will weigh on the coming fourth-quarter gross domestic product report. Central to the analysis of that data is recognizing that the Fed has moved ahead of any substantial slowdown in the economy and is prepared to take more action if needed. 

In other words, don’t think we are waiting around for the Fed to do something. It already has. Central bankers see your recession call and are working to make sure you are on the wrong side of that bet. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

©2019 Bloomberg L.P.

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