Three of the last four U.S. recessions stemmed from unforeseen shocks in financial markets. Most likely, the next downturn will be no different: the revelation of some underlying weakness will trigger a retrenchment of investment, and the government will fail to pursue counter-cyclical fiscal policy.
Over the past 40 years, the U.S. economy has experienced four recessions. Among the four, only the extended downturn of 1979-1982 had a conventional cause. The U.S. Federal Reserve thought that inflation was too high, so it hit the economy on the head with the brick of interest-rate hikes. As a result, workers moderated their demands for wage increases, and firms cut back on planned price increases.
The other three recessions were each caused by derangements in financial markets. After the savings-and-loan crisis of 1991-1992 came the bursting of the dot-com bubble in 2000-2002, followed by the collapse of the subprime mortgage market in 2007, which triggered the global financial crisis the following year.
As of early January 2019, inflation expectations appear to be well anchored at 2% per year, and the Phillips curve – reflecting the relationship between unemployment and inflation – remains unusually flat. Production and employment excesses or deficiencies from potential-output or natural-rate trends have not had a significant effect on prices and wages.
At the same time, the gap between short- and long-term interest rates on safe assets, represented by the so-called yield curve, is unusually small, and short-term nominal interest rates are unusually low. As a general rule of thumb, an inverted yield curve – when the yields on long-term bonds are lower than those on short-term bonds – is considered a strong predictor of a recession.
If a recession comes anytime soon, the U.S. government will not have the tools to fight it. The White House and Congress will once again prove inept at deploying fiscal policy as a counter-cyclical stabilizer, and the Fed will not have enough room to provide adequate stimulus through interest-rate cuts. As for more unconventional policies, the Fed most likely will not have the nerve, let alone the power, to pursue such measures.
As a result, for the first time in a decade, Americans and investors cannot rule out a downturn. At a minimum, they must prepare for the possibility of a deep and prolonged recession, which could arrive whenever the next financial shock comes.
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