Holes in the recession story

August 18, 2022 06:00
The US Bureau of Labor Statistics’ July employment report, for example, was markedly stronger than expected. Photo: Reuters

With so much talk of stagnation, inflation, and stagflation in recent months, it is worth questioning whether the prevailing pessimism is justified. While I have shared in the gloom (warning early on that it could be a “bad year for markets”), I’m starting to reflect on my previous views, for four reasons.

First, I am struck by just how widespread the recession narrative has become. Almost everyone seems to believe that developed countries are heading into, or are already in, a recession. I have given multiple interviews to business consultants who all want to know “how to prepare for the recession.” As I remarked to one of them, I know of no previous recession that was so confidently anticipated as the one that is supposedly upon us now.

After all, the main reason that “recession” is such a scary word is that recessions are usually unexpected. Economic forecasters tend not to see them until they have already arrived. That is what happened in 2007-08 (which was admittedly rather unique) and again in 2020, following the arrival of COVID-19. Yet now, even some central banks (namely, the Bank of England) are openly forecasting a recession later this year. Has economic forecasting suddenly become better, or is something else going on?

True, two consecutive quarters of negative GDP growth is usually taken as a sign that an economy is in recession, and US GDP does appear to have fallen in the first two quarters of this year. But, surely, we should consider the specific reasons for the apparent contraction. Some of them, like the sizeable drop in inventories, tell a story about the broader economy that is contradicted by other indicators. The US Bureau of Labor Statistics’ July employment report, for example, was markedly stronger than expected. In light of that data, I would not be surprised if the National Bureau of Economic Research (the official arbiter) declares the US not to be in recession.

The second reason for my skepticism about the prevailing narrative is that not all medium- and long-term indicators point to sustained higher inflation. The closely watched University of Michigan five-year inflation expectations index may have briefly risen above 3%, but it has since fallen back to 2.9%, suggesting that average consumers regard this year’s huge surge in inflation as temporary. Yes, if you are on the Federal Reserve Board, it is far too early to be too confident in this finding. But if consumer sentiments do continue to ease in the coming months, I suspect that the Fed will become less hawkish.

Third, while many commodity prices remain significantly elevated from this time a year ago, they, too, have eased in recent weeks. Were they to remain relatively stable, headline inflation in many countries would start to fall – perhaps significantly. Interestingly, while the BOE’s forecast of a recession and even higher inflation has gotten plenty of attention, few seem to have noticed that the central bank ultimately expects inflation to fall sharply from its anticipated higher peak throughout most of 2023.

Finally, in most investment-bank research notes nowadays, there is a strong assumption that central banks will vigorously fight any financial-market rally, because they cannot afford to let financial conditions ease in the current environment of low unemployment, upward wage pressures, and concerns about inflation. Yet while this has certainly been the message that one hears from central bankers, I tend to rely on the adage that, “If you can be sure of anything, it is that central bankers will at some point change their mind about the economic climate.”

No one is clairvoyant. Recall that throughout 2020 and much of 2021, the consensus among central bankers was that inflation was transient. Though they have since changed their tune, it may turn out that they weren’t entirely wrong after all.

Again, it is too early to be too optimistic. I don’t want to give the impression that recession fears are unwarranted. If the recent dip in inflationary signals (such as commodity, house, and used-car prices) and long-term inflationary expectations reverses, I would have to backpedal. But having lived and breathed financial markets for the better part of 40 years, I am always intrigued when there is such a strong consensus about something – especially when some of the actual evidence runs against it.

In any case, I certainly hope that the pessimism does turn out to be overdone. Advanced economies are facing major challenges, not least persistently weak productivity growth, which has negative implications for many other domains of social and economic life. We will be facing massive, recurring challenges in the coming years no matter what. It would come as a modest relief to learn that we had let doom and gloom get the better of us.

Copyright: Project Syndicate
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Jim O’Neill, a former chairman of Goldman Sachs Asset Management and a former UK Treasury Minister, is Chair of Chatham House.