In this podcast, co-hosts Luke Bartholomew and Paul Diggle speak to abrdn’s Deputy Chief Economist about the US-led global recession we are forecasting.



James, Paul, Luke Bartholomew

Luke Bartholomew 00:06

Hello, and welcome to macro bytes the economics and politics podcast series from abrdn. My name is Luke Bartholomew, and today, my co-host, Paul Diggle and I are joined by James McCann, our deputy chief economist to discuss the next recession. And that is because we here at abrdn are now forecasting a US led global recession, starting in the second half of next year. And there's a lot of recession chat going on at the moment. As we sit here in late June, the Fed has just stepped up the pace of its monetary tightening. And there's been some sense in which the data seems to be weakening quite sharply, all of which we'll address today. But we also want to take a step back and ask some slightly deeper questions as well about the nature of forecasting recessions. But before we get to all of that, it probably be useful to talk about how it is that we came to this view that we are now expecting a recession next year, and then there are several ways of approaching the question. And one of those is through historical comparison, looking at previous episodes of monetary tightening, like the one we're going through now, and trying to draw lessons from that. So, Paul, what is it that we can learn from history? What does history teaches about moments like this?

Paul Diggle 01:31

Well, I think the key lesson from past rate hiking cycles is that they usually do end in a recession. Soft Landings are the exception and hard landings are the norm. So if you look back at US monetary policy hiking cycle since 1950, the US had 15, depending on exactly how you define it rate hiking cycles, only three of those have been soft landings, i.e. they've avoided, eventually leading to a recession, those were in 1965,1984,1994. Every other hiking cycle resulted in a recession within a year or two, sometimes much sooner. Now, that ratio isn't quite as skewed if you look outside the US, and nor was every single US recession since 1950, caused in and of itself directly by the rate hikes. I mean, think about the 2020 COVID recession, rate hikes started in 2015. It wasn't like they then caused the recession, there was a shock, the Covid shock that occurred there. But in many cases, rate hiking cycles have played a role in subsequent recessions. So I think that's the big lesson of history. What do you need to actually get a soft landing instead of a hard landing? You need the Fed to start ahead of the curve, right? You need to have some slack in the labour market still, when the rate hiking cycle begins, you need wage and price pressures that aren't really as severe as they are now. You need financial imbalances to be relatively contained. Those conditions don't really apply today. So it's, I think that the burden of proof is therefore on showing why there wouldn't be a recession, right, not why there would. You’ve got to reframe the question properly and say, usually you get recessions, but why wouldn't we this time around.

Luke Bartholomew 03:33

So James, Paul has set out the conditions that history seems to suggest need to be met to avoid a recession, where the burden of proof is. He sort of suggested that we aren't seeing those conditions, but maybe you could give a little bit more colour about, you know, what it is that we're seeing in the labour market and other sectors of the economy that make us so worried?

James McCann 03:54

Absolutely. And I think, you know, certainly some ominous historical precedents. And I think that signal that this, the job of the Fed during a tightening cycle is much harder when the economy is facing deeper imbalances. There is less slack, the inflationary pressures coming through a more robust, it's behind the curve in tackling those. These are all problematic. And when we look, let's start with the labour market. When we look at that as a benchmark for where the economy sits in the depths of the imbalances, it looks, it looks really worrying. Headline unemployment rate of 3.6%. And we only seen them on employment rate lower one time in the last 50 years, and that was at the end of the previous cycle. But maybe diving down into the labour market in more depth, back in 2019 when we got to 3.5% unemployment, there were 1.2 vacancies for every person unemployed. Now there are 1.9 vacancies. So actually, on some measures, this is a labour market that just looks tighter than it’s ever looked. And some recent research, a really interesting paper by Larry Summers and colleagues, suggested that degree of mismatch between vacancies unemployed workers is the equivalent of an unemployment rate which sits closer to 2% than three and a half. So, you know, really the Fed might be battling against the labour market that's never looked tighter and in some in some measures.

Luke Bartholomew 05:15

So given the extremely tight labour market backdrop, we've of course seen the Fed already deliver a fair bit of monetary tightening and recently seems to have stepped up the pace in which it intends to do that - and that's had quite significant implications for asset prices. So James, you want to give us a quick summary of what the Feds done so far, what we expect it to do? And then sort of, you know, given that we've already seen such a large fall in asset prices, I mean, is there a sense in which that in and of itself is enough to bring about this recession we're talking about?

James McCann 05:47

Yeah, absolutely, as Paul mentioned at the start, yeah, it's this this job is easier for the Fed when it's ahead of the curve. And I think we've been, I think it's very clear that a central bank delivering very large interest rate increases over short spaces of time clearly doesn't feel it's ahead of the curve, the Fed is clearly behind the curve and is running, sprinting to try and catch up. So already, we've had a significant degree of monetary tightening. At the most recent meeting the Fed delivered a 75 basis point increase. It had been signalling until very recently that that will be 50 basis points. But I think changed course, on the back of some quite alarming inflation, and in particular inflation expectations data. It's signalling a very aggressive pace of rate hiking, continuing. So it has interest rates peaking around three and a half percent by the end of this year. And in 2023, the terminal rate reaching not far off 4%. So peaking, according to their summary of economic projections released last week, or 3.8%. So to get to get under the surface of that, really, what the Fed is saying is, we're in a real hurry to get the interest rate structure higher, and we're no longer looking to just get rates from accommodative, where they probably still stand at the moment and they've stood now for a couple of years, since the Covid shock. We're looking to get those aggressively tight. So beyond neutral where policy, so it doesn't play a very significant role on activity to tight - where policy is aiming to actually slow growth and slow the economy. And you're absolutely right markets are pricing this and reacting to this in a difficult way. And I think there are a few facets going on here. One, obviously, the discount rate is rising very significantly, and that causes them to need to adjust, when they're thinking about future discounted earnings, to you know we've called the recession, markets are flirting with how to price this this downturn. And I think three the most interesting factor here is how all this can become self-reinforcing. You know, certainly the degree of market angst that we've seen over recent sessions has caused financial stress to increase remarkably, as I mentioned, there’s information in that in which we can see the market becoming increasingly concerned about the cycle, about the path for interest rates too. We know that that in itself can go on and create its own economic drags, as risk taking becomes more muted, as the cost of, and difficulty of, finding that finance becomes more and more scarce. So in itself, the financial stress, we think is large enough to create a significant economic drag. And that really just adds to our concerns around the cycle. And I think, illustrates the difficulty the Fed has got in trying to pull off this balancing act.

Luke Bartholomew 08:27

And you said then that there is inflammation in the movement we've seen in asset prices. The fall in stock markets probably tells us something about the state of the economy. But Paul Samuelson, famous 20th century economist once joked something to the effect of that the stock market has predicted nine of the last five recessions, the idea that, you know, it's fallen quite frequently and many times that hasn't actually turned into recession. And equally, economists themselves aren't necessarily much better at predicting recessions than the market is. The IMF has done a fair bit of work showing that economists seem to be systematically poor at predicting recessions, see it coming too late, don't mark their forecasts down enough. And I think we all know, relatively well, that economists can be the butt of various jokes about this recession forecasting track record. So I suppose my question, Paul, is, why is forecasting a recession so difficult? Why all these jokes?

Paul Diggle 09:23

Yeah, well, I mean, the first thing to say is a lot of recessions are caused by exogenous shocks, unforecastable outside things that hit the economy. So Covid in 2020, was, that's an obvious example. I mean, the Yom Kippur War in 1973, led to the oil shocks and multiple recessions of the 70s. It was kind of outside of economics, and difficult to forecast. So a lot of these things kind of happen and hit you. But the other I think, maybe the deeper point, is that recessions in a sense, should be unself-fulfilling. That is to say, if policymakers, economists, central bankers, governments knew a recession was coming, they forecast a recession. Well, they should then have the policy tools to prevent said recession happening, at least in kind of some perfect models of the economy, you could cut interest rates, you should you could do fiscal stimulus, and you could stop the recession occurring in the first place. So in that sense you might think of them as, as unself-fulfilling, and that doesn't completely hold up. I mean, James talked about the feedback loop between fears of a recession, rising markets selling off, consumers and businesses retrenching, confidence getting hit, what we call the ‘paradox of thrift’ kicking in, and the recession becoming self-fulfilling. But at least in some kind of perfect models, it should be very difficult to forecast recessions well in advance. They should only really be the result of unforecastable shocks and policy errors. And the other thing I think that’s worth saying is that economists and markets both do have poor track records in forecasting recessions but in different directions, right? Economists under forecast recessions, we can be sometimes slow to update our forecasts. There's kind of the risk of being wrong with everyone else, and not forecasting a recession is worse than the risk of being wrong on your own – and you forecast a recession no one else does. By contrast, markets can be quite volatile, sentiment-driven, they can herd, they can overreact, and hence the Samuelson quote that they actually over-predict recessions. So it's a difficult business.

Luke Bartholomew 11:49

Well, as economists like to say, incentives matter. So I suppose given those incentives that you've just described there, and also that analysis around potentially unself-fulfilling dynamics, why is it that we are forecasting this recession? What is different? What's going on about what makes this one special?

Paul Diggle 12:07

Well, I'd love to say we're just an incredible group of forecasters and we can see what everyone else can't. But actually, I think the reason is that this recession is a feature, not a bug of monetary policy at this point. It's not an unexpected, unforecastable downturn. Rather, it's a necessary, in some sense, necessary downturn, to raise the unemployment rates sufficiently to bring inflation back under control. That's why we think we can forecast it and we have it in our projections, because we struggled to see any other way of bringing about the necessary cooling in the labour market, bringing the unemployment rate up, as James was talking about, to control inflation, without a recession occurring. And that's also by the way, why sort of the so called ‘Fed put’ the Greenspan put where, you know, financial market sells off a lot on fears of an interest rate hiking cycle, then in turn may cause the central bank to rein back its interest rate, hiking cycle. That dynamic’s probably not actually operating this time around. Because the Fed and lot of global central banks need markets to tighten, to bring about the necessary tightening in financial conditions, that is going to slow growth enough to rebalance the economy. In a sense, the policy error isn't to come. It's not an over tightening, which is coming. It's already occurred, it was allowing the economy to get to this point of such a low unemployment rate, such a hot labour market, and such a high rate of inflation. Now there's no choice or at least in our baseline, it's very difficult to see anything other than a recession, actually dealing with the situation.

Luke Bartholomew 14:00

So I think the point that it's not necessarily a policy error at this point to cause the recession. But is it entirely fair to describe it as a policy error that got us to this place in the first instance? There's of course been a huge number of unexpected shocks around supply chains, or in Russia / Ukraine, and what commodity markets have done. And as I look back, I mean, we've talked many times about the fiscal policy, monetary policy impulse in generating a recovery from the Covid recession. I think it's fair to say that many of our concerns were that there would be a repeat of the recovery of the global financial crisis, which is to say, insufficiently strong policy response, the policy error would be that there just wasn't enough demand generated. So given those unexpected shocks, and that sort of sense about where the balance of risk lies, yeah, I mean, is it fair to call what's happened to policy mistake?

Paul Diggle 14:59

I mean, something’s gone wrong along the way. It's not just central banks, which have kept monetary policy too loose. It's also perhaps governments, which in hindsight added too much fiscal stimulus. And there were economists out there, not the majority of economists, but there were some like Larry Summers, like Blanchard, saying, perhaps we're overdoing it here. But the majority of economists, policymakers were in a sense fighting the last war, were coming out of the financial crisis there was under stimulus. And that's why we got a decade of quite anaemic growth – they were responding to that with keeping rates looser for longer, doing more fiscal policy, not less. So that was the policy error. But that's not to, I think, be too harsh on policymakers, there was also an enormous exogenous shock fear, right? Who knew quite how the pandemic was going to play out how quickly demand was going to snap back, but how persistently the hit to supply and the disruptions to supply chains, the mismatches in the labour market, were going to stick around. So a lot that was going on was completely unprecedented. I mean, looking ahead, my worry is just as we were fighting the last war by providing a lot of stimulus after the pandemic, because that's what didn't happen after the financial crisis, perhaps, come the next shock, the next downturn will be over-extrapolating the lessons of today, and perhaps won't do enough monetary and fiscal stimulus. So there'll be this kind of seesawing, which means always fighting the last war, and never quite setting perfect macro policy.

Luke Bartholomew 16:47

So before we get to that next war, I suppose you've actually got to have the recession in the first place. And as I said, we're looking for it to start in the second half of next year. But right now, there's already seemingly a lot of concern that we're already in a recession, the first quarter of US GDP growth actually showed a contraction. And there are tracking indicators now which seem to be consistent with extremely low growth in this quarter. So, James, what do you make of the argument that we're already in a recession. Are the data that we're seeing at the moment consistent with that reading of the economy?

James McCann 17:24

I don't think they are now. I think when we look back at that first quarter contraction, underneath the hood of the GDP data, it was a relatively healthy report, consumer spending was growing about 3% annualized. There was spending on sort of big ticket durable goods items of 7% annualised over the quarter, fixed income up around 7% too. So I think what really happened there is that strong domestic demand drove very, very strong imports, and maybe some temporary or improvements in global supply chains towards the end of last year, early this year, helped suck in a bit more on the import demand. And so you've got quite a big negative trade shock, which pushed down there is aggregate numbers to some extent. So I think that really overplays the weakness we saw at the start of the year, it's certainly the case that we're seeing some slowdown in consumer spending some moderation too in business investments. We're in the midst of a very significant energy price shock at the moment. So that may not be, you know, hugely unexpected. Our expectation now is that in Q2, we do get a positive growth number. Appreciate that some of the nowcasts are tracking towards flattish growth over the quarter - but we're still relatively early in the data tracking. And I think critically, they're not picking up as yet much trade data, which, you know, following that very, very big net exports shock in Q1 we do think we'll at least partly reverse that even if some of aspects of domestic demand start to start to slow. I think, alongside that net trade picture, we should get some improvement. So I don't think we'll get that two quarters of negative growth. And, and even if we did, it's not impossible, even if we even if we did, I don't think that would sort of meet the benchmark for what we consider a true recession, even if it might fall into the technical recession camp.

Luke Bartholomew 19:10

So as Obi Wan Kenobi didn't quite say, this is not the recession that you're looking for. Maybe this is not so much what we're worried about, perhaps a good final question would be to ask, what would be the signs that would make us less concerned about the recession we truly are worried about? What kind of things would we need to see to make us more confident that actually the economy could avoid this trap?

James McCann 19:33

Yeah, I think there are a few things. I mean, we go back really to, to the Fed’s mission in bringing down inflation and they're going to attempt to do that. Their I suppose communication is that they can do that without a recession. They were very clear in their latest projections that they thought they could lower inflation while only creating modest labour market stress and slightly below trend growth. So for that to come off really I think we need to lean a lot on the supply side and what I mean by that is some of the pressure in the labour market is eased by people flooding back into the labour force and more readily taking jobs, maybe some improvement in the matching between those looking for jobs and the job vacancies that are available at present as well. I think that would certainly help. An improvement in global supply chains, we just take some of the heat out of the durable goods sections of inflation, which would be really, really helpful at the moment as well. We had seen as I mentioned earlier, some tentative progress maybe around the turn of the year around improvements in global supply chains, but obviously with zero Covid in China and war in Europe, these improvements have been stymied to some extent. So I think those are the types of things we'd be looking for. A bit of supply side indicators that the labour force was loosening, not because of weaker job demand necessarily but maybe because of stronger labour supply, that durable goods inflation was starting to moderate not because people wanted to buy less stuff but more because that stuff was more quickly getting produced and sent across the world into US inventories. So those are the things I think the Fed would see as really positive signs that it's able to pull off this rebalancing without doing so much economic damage that the economy inevitably goes into recession.

Luke Bartholomew 21:18

That is all we have time for today. So as ever, let me remind you to please do like and subscribe to this podcast on your podcast platform of choice. Thank you, James and Paul, for your excellent insights. I must admit that this is a forecast that I rather hope we do get wrong, which is not often what a forecaster would say. But with that, thanks very much for listening and speak to you again soon. Thanks very much. This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for informational purposes only and should not be considered as an offer, investment recommendation or solicitation to deal in any of the investments or products mentioned herein and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication, and do not necessarily reflect those of abrdn. The companies discussed in this podcast have been selected for illustrative purposes only, or to demonstrate our investment management style and not as an investment recommendation or indication of their future performance. The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested. Past performance is not a guide to future returns, return projections or estimates and provide no guarantee of future results.