Where is the recession we were promised?

Markets spent last week focusing on earnings with little important economic news. The upcoming week will be dominated by the Fed meeting on Tuesday and Wednesday. The Fed Funds futures are a lock for another 25 basis point increase in the Fed Funds rate and the futures for the rest of the year are pricing in about a 25% chance for another hike.

Strategists are beginning to think rate cuts are not in the cards until the second quarter of 2024. Given the strength of the labor market, it is hard to come up with a recessionary scenario. The Atlanta Fed’s GDP Now model sees Q3 GDP growth coming in at 2.4%. It is astounding to think that after 500 basis points in rate hikes over the course of 15 months that GDP would still be this strong. Historically such an aggressive tightening regime would cause a deep recession, but those calling for a recession and rate cuts this year have been dead wrong.

I think part of the reason for this has been that for most of this tightening cycle, real interest rates (i.e adjusted for inflation) were negative. Take a look at the chart below, which shows the YOY increase in the consumer price index versus the Fed Funds rate. Even during a “tightening” regime, monetary policy was still exceptionally loose.

I think this explains why we haven’t seen a recession yet - real interest rates just turned positive in April. So for most of this cycle, monetary policy was still highly stimulative even though the Fed was “tightening.” It reminds me a bit of how the press used to call massive deficit spending after 2009 to be “austerity.” This was an ideological term meant to convey that since the government was spending less than the year before the government was worrying too much about the deficit. Of course this was all pure eyewash - fiscal policy was still highly, highly stimulative. It is like saying that someone who runs up $25,000 in credit card debt is “austere” for only running up $24,000 in the following year.

And don’t forget, the Federal Government is still stimulating the economy as well. So that could be holding back a recession as well. In terms of overall stimulus, the US has been going at ludicrous speed for years, and we are about to downshift to ridiculous speed. In other words, a recession might not have materialized yet because monetary policy was not “tight” under any normal definition of the term. It will be an interesting test for the economy to see how it performs when government spending returns to normal levels and real interest rates approach r* (also called r-star) which is the natural neutral rate of interest where monetary policy is neither stimulative nor restrictive. Pre-pandemic, it was considered to be about 2%.

If you look at the CPI ex-food and energy (or the sticky price index, and compare that to the Fed Funds rate, you’ll see that we are still experiencing negative real interest rates.

Take a look at the early 1980s, if you want to know what tight monetary policy looks like. In 1981, Paul Volcker took the Fed Funds rate to 19% when inflation was running at 9%. That is what tight monetary policy looks like, and under today’s environment it would be like taking the Fed Funds rate to 15%. With the Fed Funds rate heading to 5.25%, the sticky CPI would have to fall to 3.25% to approach r star. So why haven’t we had a recession yet? Maybe it is because monetary and fiscal policy aren’t remotely restrictive.

That said, the yield curve is still highly inverted, and the Index of Leading Economic Indicators is in recessionary territory. Consumer confidence stinks as well. So we are seeing some indications that the groundwork for a recession are being laid, and once inflation falls enough that we approach r-star we will see one. Until then the economy will probably chug along on borrowed time.

Aside from the Fed Funds rate, the Fed also uses the money supply to regulate the economy. The money supply is shrinking at the fastest clip ever. Of course the jump in the money supply early in the pandemic was the fastest clip as well. The money supply generally grows over time, so there is a long-term trend line. The current money supply is still above long-term trends, however we are approaching it.

The other side of the money supply is the velocity of money, and that recovering from record lows.

The velocity of money measures how quickly money changes hands. Velocity had been falling for a long time, and it collapsed during the pandemic. Why this has happened is a bit of a mystery, but it may have been that Americans saved, invested or paid down debt a lot during the pandemic.

Overall, I suspect that once monetary policy actually becomes restrictive we will have a recession and we are probably looking at 2024 when it kicks in.