March 28, 2022
There is a story of a football coach who ran running plays near the end of a game, when he clearly should have been passing. Apparently, he had seen data showing that teams that win, on average, run on a certain number of plays. His team was below this number, so he decided that he had to have more runs if his team was going to win.
This is a classic case of confusing correlation with causation. (For those not familiar with football, when a team is ahead, it generally uses running plays to take lots of time off the clock. They run because they are winning, they don’t win because they run.) This distinction is important when considering various predictions for a recession in the current environment.
There are many features of an economy that we commonly see before a recession. For example, we typically see higher prices for oil, wheat, and other commodities before a recession. We also often see an inverted yield curve, where the interest rate on short-term Treasury debt (e.g., 90-day or 2-year notes) exceed the interest rate on 10-year Treasury bonds.
We are currently seeing a serious run-up in many commodity prices. It’s very plausible that we will see an inverted yield curve in the next year or so. The question is whether this means we should be expecting a recession in the near future?
While I would not rule out a recession beginning this year or next, we have to be careful to ask about the causation and not just look for events that tend to be correlated with recessions. Neither high commodity prices nor an inverted yield curve should be sufficient grounds for believing we will see a recession.
The Problem of High Commodity Prices
Taking these in turn, the impact of high commodity prices on economic growth is ambiguous. Higher prices for gas and food (insofar as commodity prices get passed on in food prices) will take money out of households’ pockets, meaning that they have less money to spend on other things. In this way, they can be thought of as being comparable to tax increases.
However, there is a flip side to these tax increases. Higher commodity prices, especially in the case of oil, provide incentive to invest more money in the search for more oil. With the explosion of fracking in the United States, much of this investment is likely to take place here. This investment will provide a boost to demand that can partially, or even fully, offset the extent to which higher oil and gas prices reduce consumption.
There is a complicating factor in this story. The plunge in oil prices from 2014 to 2015, which took prices from over $100 a barrel to roughly $40 barrel, brought a quick end to the fracking boom. The whole industry was hard hit and many companies went bankrupt.
This history has made many companies reluctant to invest in a big way, even as oil prices again soar to over $100 a barrel. Nonetheless, the number of oil rigs is up by more than 50 percent from its year ago level, even though it is still far below the pre-recession figure. It seems likely that if oil prices stay high that we will see continued rapid growth in drilling, with the investment largely offsetting the drop in consumption due to higher gas prices.
The story with other commodities is similarly ambiguous. Higher grain prices mean higher incomes for farmers. Also, the price of grain is a relatively small factor in our food prices. (They matter much more for people in the developing world.) Most of the increase in food costs since the pandemic reflect higher shipping costs and increased profits, not a rise in grain prices.
It is also important to remember that commodity prices are hugely volatile with both upward and downward swings that are often far larger than is warranted by market fundamentals. This could be the case with sharp rise in many prices since the Russian invasion of Ukraine.
For example, much discussion of the oil market has treated as a serious possibility the complete loss to world markets of Russia’s exports of five million barrels a day. As a practical matter, that scenario is almost impossible. While the United States and some other countries are now boycotting Russian oil, most of Europe is still buying it.
However, even if the European Union were to go along with a Russian oil boycott, most of this oil would still not be lost to world markets. In all probability, many other countries, most importantly China and India would still be buying Russian oil. These countries would likely buy most of the oil that the US and EU were boycotting, presumably get a discount off the world price for their willingness to flaunt sanctions.
Since demand for oil in China and India is not going to increase to absorb the Russian oil, the Russian oil will displace oil that they are currently importing from other countries. This means that oil from Saudi Arabia, the United Arab Emirates, and other countries, that used to go to China and India, will instead be going to the EU or the United States. There clearly will be some oil lost in this story (not all oil is perfectly substitutable) but the net effect will be hugely less than the full amount of Russia’s exports.
There is a similar story with grain prices. In many places grains can be easily substituted for each other. This means that if wheat prices rise a great deal, due to the loss of production from Ukraine, people in many areas may switch to corn, rice, or other grains. This will limit the extent of the price increase in areas where people have no choice but to buy wheat.
There are many factors that can affect commodity prices over the next couple of years and it is possible that the price of oil, wheat and other commodities will rise even further. But the claims that have often been made in the media do not justify the price increases that we have seen to date.
The Inverted Yield Curve
The other recession scare story, the inverted real curve, has more foundation in reality. Most recessions in the post-World War II era have been caused by the Federal Reserve Board raising interest rates to slow the economy. A slower economy reduced job growth, which reduces inflationary pressures, by putting downward pressure on wages. The exceptions were the 2001 recession, which was caused by the collapse of the stock bubble, the 2007-09 recession which was caused by the collapse of the housing bubble, and the 2020 recession, which was the result of the pandemic.
Short-term interest rates move much more than longer term rates. If the overnight money rate, that the Fed directly controls, rises by 2.0-2.5 percentage points over the next year and a half, as is now widely expected, it is likely to far exceed the increases in longer term interest rates. This creates the possibility of an inverted yield curve, where shorter term rates exceed longer term rates.
In this situation, we may well expect to see a recession, but the key factor is the Fed’s increase in shorter term rates. The Fed’s goal in raising rates is to slow the economy. If it pushes the economy into a recession, then it will have gone too far.
We may also see an inverted yield curve in this situation, as short-term rates are pushed higher by the Fed. In addition to not rising as much as short-term rates, long-term rates may also be held down by an expectation that a recession will imply lower short-term interest rates in the future. But the inverted yield curve is not the cause of the recession. It is a phenomenon that goes along with a recession.
Will We See a Recession?
There is a real risk that in the effort to slow inflation, the Fed goes too far and pushes the economy into a recession, but this is still very far from a done deal. The economy had been growing very rapidly in the fourth quarter of 2021. It would have to slow sharply from that pace to push the economy into a recession.
That is a possible story. Rapid consumption growth was the biggest factor pushing GDP higher in the recovery. This growth was fueled in part by the pandemic checks sent out to people in the CARES Acts and the Biden recovery package, as well as the unemployment insurance supplements. These payments are now in the past. People still have more money in their bank accounts than before the pandemic, but thus far they have not spent from these savings to any substantial extent.
Higher interest rates will also directly discourage consumption of items typically bought on credit, like cars and major appliances. Higher rates also have already put an end to a refinancing boom, that allowed for interest savings of thousands of dollars a year for tens of millions of homeowners. Also, to some extent the spending we saw over the last year and a half will directly depress future consumption. If someone bought a new car in 2021, they are unlikely to buy another one in 2022.
For these reasons, it is very likely that we will see a sharp slowing of consumption in 2022, which will in turn depress overall growth. But, the flip side of this slowing of consumption growth is that it should alleviate the supply chain problems that have played such a central role in driving up inflation. If the demand falls for cars, refrigerators, and other goods that people bought in large quantities in 2020 and 2021, we may see their prices fall back towards pre-pandemic levels.
We have already seen this story with televisions, where a 6.3 percent drop in prices over the last five months, has largely reversed an 8.7 percent increase between March and August of last year. We also may be seeing this story with used cars. Used car prices soared in 2020 and 2021, with the index rising by more than 50 percent between February 2020 and January 2022. However, prices began falling in February. In one private price index, by the middle of March, used car prices had fallen almost 6.0 percent from their January peak.
If these price reversals continue, and are seen in other items that saw rapid inflation during the pandemic, then we will have much less inflation for the Fed to fight. This presumably means fewer rate hikes and less of a hit to the economy.
It is also worth noting that growth in other sectors is likely to help support the economy, even if consumption growth is weak. We are seeing a boom in housing construction, which is likely to persist, even in the face of rising interest rates. House prices have risen by more than 30 percent over the last two years, which should mean that builders can still make healthy profits even if they have to pay somewhat higher interest on the money they borrow.
Nonresidential investment has also been strong, in spite of weakness in the construction of office buildings and other non-residential structures. And, the government sector should also be boosting growth, as the Biden infrastructure package takes effect and state and local governments spend more of the money they accumulated from the various pandemic rescue packages.
In short, while there are real grounds for being concerned about the risk of a recession, there are also good reasons for believing that the economy can continue to grow at a healthy pace. In any case, we should keep our eyes on the forces that actually drive the economy, and not be distracted by quirky recession signals that don’t tell us anything.