The United States is in danger of entering a recession, as its economic history proves

The United States is in danger of entering a recession, as its economic history proves


With US inflation reaching 7.9% in February 2022, the Federal Reserve decided to raise rates by 0.25 points at its March meeting. The latest summary of economic projections (2022) from the Federal Open Market Committee (FOMC), published at the same meeting, assumes that interest rates will reach 1.9% by the end of 2022. central banks without dragging the US economy into recession has been the subject of much debate.

Fed chief Jerome Powell told lawmakers in early March that he thought a soft landing was “more likely than not”. The FOMC’s March forecast and the consensus of the Philadelphia Federal Reserve among professional forecasters confirm this: In both cases, inflation will fall back below 3% in 2023 and unemployment will remain lower, at 4%.

Lean on history

To examine the plausibility of the Fed’s forecasts, we look at quarterly data from the 1950s and calculate the probability that the economy will enter a recession within the next twelve to twenty-four months, assuming alternative measurements of inflation and unemployment.

Our analysis is motivated by the fact that overheating conditions such as low unemployment and high inflation are usually followed by short-term recessions. Antonio Fatás, for example, showed in 2021 that the US economy had never experienced significant periods of low and stable unemployment, as predicted by the FOMC.

Our main conclusion is that given current inflation (close to 8%) and unemployment (which remains below 4%), historical data suggest a very significant likelihood of a recession in the next twelve to twenty-four months.

High probability of recession

Table 1 shows the historical probability of a recession in the next two years based on current measurements of inflation (measured by the consumer price index, CPI) and the unemployment rate.

The results suggest that lower unemployment and higher inflation significantly increase the likelihood of a subsequent recession. Historically, when average quarterly inflation exceeds 5%, the probability of a recession over the next two years is over 60%, and when the unemployment rate falls below 4%, the probability of a recession over the next two years approaches 70%.

Between 1955 and 2019, there was never a quarter with average inflation above 4% and an unemployment rate below 5% that would not be followed by a recession in the next two years.

The above results do not reflect our choice to use the CPI rather than other measures of inflation or to use the unemployment rate rather than other measures of labor market tension. On the contrary, measuring labor market tensions using the vacancy rates we advocated in our previous work suggests an even higher likelihood of a recession in the next twelve and twenty-four months. Similarly, the use of “Core PCE” inflation or wage inflation rather than CPI leads to the same conclusions.

One might argue that the historical data in these tables overestimate the likelihood of a recession, given that there has been a trend towards greater business cycle stability over the last two decades. Motivated by this concern and in order to make maximum use of the available information, we use a probit model to predict the probability of a future recession under current economic conditions and to manage the time trend.

Heavy soft landing

Table 2 shows the results of our probit models, which show the probabilities of recession over the next twelve and twenty-four months for five different model specifications. In our basic model, we use the four-quarter average inflation and the quarterly unemployment delay as the main explanatory variables.

To account for the possibility that the probabilities of a recession have decreased over time, we also have specifications that include a time trend (column 2) and a notional variable for the years after 1982 (column 3). In our regressions, we find that the trend towards greater stability of the economic cycle does not appear significantly after the control of economic conditions.

Finally, we include a specification with a dummy indicating whether the economy is more than six quarters away from economic expansion (column 4), and with a time trend and a dummy expansion (column 5).

These results indicate a very high probability of recession in the coming years across many model specifications. Moreover, they do not reflect our choice to use the CPI as a measure of inflation or the unemployment rate as a measure of laziness.

The use of wage inflation rather than consumer price inflation leads to an even higher likelihood of a recession, and the use of core consumer price inflation makes similar predictions. Replacing the unemployment rate with the vacancy rate (which we believe is a better indicator of stress) also provides higher predictions of the likelihood of a recession in the next few years.

Taken together, the evidence we present suggests that it is very difficult to make a smooth landing in a fast-growing inflationary economy.

The Fed is late

Some argued that there was reason for optimism because there were several soft landings in the post-war period, including 1965, 1984 and 1994. But in each of these periods, inflation and labor market tensions were little similar today. Table 3 summarizes labor market conditions during these so-called soft landings.

Note: This table uses the quarterly averages from the first quarter of the economic contraction cycle.

During all three episodes, the Federal Reserve operated in an economy where the unemployment rate was significantly higher than today, where the vacancy to unemployment ratio was significantly lower than today, and where wage inflation was below 4%.

In these examples, the Federal Reserve also raised interest rates well above inflation – unlike today – and acted explicitly early to prevent inflation from rising, rather than waiting for inflation to become too high. Even these periods have not been marked by large supply shocks, such as those currently experienced by the United States.

With inflation close to 8% and an unemployment rate below 4%, the Fed is now far behind the curve and now needs to catch up in an effort to keep rising prices in check. The historical experience of the United States is far from encouraging optimism, but it shows that a rapid acceleration in inflation always leads to a substantial increase in economic room for maneuver.

Our conclusion is in line with that of Jongrim Ha, Ayhan Kos and Franziska Ohnsorge, who argue that the return of inflation to the target is likely to require a much stronger political response than currently expected. In addition, none of the calculations in this column take into account the recent supply shocks related to the war in Ukraine, which will only further increase the likelihood of a recession. It is therefore unlikely that the Fed will achieve a soft landing economy.





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