Why The US Fed Has To Keep Tightening Even Though The Most Reliable Recession Indicator Is Flashing “Game On”

It may be hard to believe, but modern macroeconomics actually has a few theories worth paying attention to. One of these is driving central bank behavior right now, and all indications — thus far — is that U.S. Fed Chairman Jerome Powell is not in the Greenspan-Bernanke-Yellen “cave in to political pressures” mold, and more of a Paul Volcker-type of central banker. And you should care about this because, in the long run, continued tightening of monetary policy is in all of our best interests. Using the two graphs below, I’m going to explain 1.) why Powell is leading the Fed in a better direction than it’s been led in at least 20 years, 2.) why the U.S. economy is most likely going to experience a brief, shallow recession, and 3.) why we should be happy about this.

Exhibit 1 below shows the Unemployment Rate in the U.S. minus the Natural Rate of Unemployment since 1950. Recessionary periods are shaded. Here’s what we learn from the graph: when the unemployment rate dips below the lowest possible rate of unemployment that will not trigger a long-term upward inflationary spiral (the “natural” rate of unemployment), we enter a countdown to the next recession. As the graph shows, this indicator has predicted 9 out of the last 10 recessions. And, thanks to the poorly-timed 2017 tax cuts, which pushed the economy past full output and lowered unemployment below 4%, the recession clock has started ticking once again.

Now, just in case you’re a “9 out of 10 ain’t good enough for me” type of person, I will point out that the 1981-1982 recession, which is the only one in 70 years that was not preceded by the unemployment rate dipping below the natural rate, was Paul Volcker’s second attempt at deliberately engineering a recession to break a vicious inflationary spiral (with a Fed Funds rate greater than 20%, well above the worst inflation rates experienced during those years). Since that recession was artificially induced and almost completely disconnected from market forces, we can give the theory a mulligan, just this once.

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Gary Anderson 1 year ago Contributor's comment

The article is interesting. There are three issues. First, no one knows how deep the recession could go. All bets are off because of tariffs. Secondly, capacity utilization is still running below 80, so we have spare capacity unless measurements are wrong. And there are stii chronically unemployed from the Great Recession. Thirdly, we have exotic structures in finance like leveraged loans and other new vehicles that could tighten up the supply of credit like what happened in the Great Recession.

Beating Buffett 1 year ago Member's comment

Good read, thanks.