Recession Update: Should We Worry?

“To expect the unexpected shows a thoroughly modern intellect.” – Oscar Wilde

Executive Summary: Bright Sunshine in the Short Run, Clouds Are Gathering Over the Medium Term

So far, 2018 shows interesting (and, to some extent, contradictory) developments. While the economic/financial world experienced some healthy gains, recession worries are also in the picture. That is, Q2-2018 GDP growth came in at 4.1 percent, and the S&P 500 Index hit 2,800 for the first time (in January 2018). The flip side of the coin is that, mainly due to the rising fed funds rate environment, some analysts are worried about the inverted yield curve and the impending risk of a recession. Furthermore, the current expansion is the second-longest expansion on record. It is true that expansions don’t die of old age, but they are not eternal either—and a recession ends an expansion phase.

To inform our readers, we updated our models to estimate the potential risks of a recession in the short run (within the next six months), as well as in the medium term (the next couple of years). Our preferred Probit model suggests a very low probability (less than 5 percent) of a recession during the next six months. The ordered Probit model, which predicts the probability of a recession as well as the strength of a recovery/expansion, also shows a very low recession possibility for the next six months. The model is suggesting above-trend growth for the rest of 2018. Essentially, our models suggest bright sunshine and no recession risk for the rest of 2018.

Last year, we developed a new framework to predict recessions in the medium term (up to two years ahead). The predictive power of the framework is significantly higher than the inverted yield curve; our proposed method predicted all recessions since 1954, but the inverted yield curve failed to predict recessions during the 1954-1965 period.1 Our proposed framework identifies a threshold between the fed funds rate and the 10-year Treasury yield, and when the threshold is breached, the risk of a recession in the medium term is significant. This threshold was breached in December 2017. Historically, when the threshold is met, there is 69.2 percent chance (average probability) of a recession within the next 17 months (average lead time). Therefore, this framework suggests that clouds are gathering over the next couple of years.

In addition, there are two major recent developments that can affect the threshold’s call. First, there is the 2018 tax cuts to consider, but we believe the net effect of the tax cuts may be neutral (and may not affect the threshold call). On the one hand, the tax cuts are likely to boost personal spending and after-tax corporate profits (at least in the short run). On the other hand, the tax cuts may put the FOMC on a faster rate-hike track, as there is a high probability of four rate hikes in 2018. The four rate hikes may take the fed funds rate close to its peak of the cycle. Historically, the peaking of the fed funds rate in a monetary cycle has been an indication of an elevated risk of a recession in the medium term.

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