Will the US See a Recession This Year? It Depends on the Fed

Author:
Markus Schomer, CFA
Chief Economist
New York

4 January 2019

When I talk to investors these days, the question I most often get isn’t “how fast will the economy grow this year?” but rather “will we get a recession this year?”

So, yes, the recession question is key right now. And the biggest factor in whether a downturn is in the cards is the US Federal Reserve and how its monetary policy evolves over the next few quarters, at least.

In one way or another, every US recession has been caused by the Fed pushing rates too high. But “too high” means different things at different points in history. So determining what’s too high is the tricky part – for the Fed and for economists like me.

Nine hikes so far – how many more?

Notably, when the Fed made its latest move on Wednesday, Dec. 19, policymakers seemed to be hedging their bets. They once again hiked the range for the benchmark fed funds rate by a quarter-point, now at 2.25% to 2.50% – the ninth increase since setting out on the current tightening cycle in December 2015. But crucially, the Federal Open Market Committee (FOMC) also indicated that the pace of hikes will slow in 2019, reducing the number of increases expected this year to just two instead of the previous forecast of three.

Such changes in the Fed’s forward guidance depend on what’s essentially a magic number: the “neutral rate of interest.” This is the point at which rates neither stimulate growth nor restrain it. The problem is that the neutral level is only ever clear in hindsight, while “monetary policymaking is a forward-looking exercise,” as Fed Chairman Jerome Powell recently said.

The median forecast among FOMC members for that perfect level of interest rates slipped to 2.75% in December, while the Fed’s widely watched “r-star model” shows a level of 2.50%. So it’s fair to say the Fed is about to enter the neutral zone.

If you go back to the previous business cycle going into 2008, the Fed had pushed its policy rate three hikes above the neutral level, which in those days – before the damaging effects of the Great Recession – was about 4.5%. Three hikes above neutral then was enough to push the economy toward the eventual recession.

Now, if the Fed raises rates again in March and June of 2019, we’ll be two hikes above neutral. With fed funds at around 3%, that rate should slow growth but not cause a recession. If the Fed goes beyond that, and we get three or even four more rate hikes this year, we’ll likely have a recession on our hands.

What kind of recession, if any?

Of course, not all economic cycles are the same. We might blame the Great Recession on the Fed’s overzealous rate hikes, but other conditions also played a role, including the US housing bubble.

One notable difference to previous cycles is the current low inflation backdrop. Unlike in the 1980s, when the Fed had to keep raising rates for an extended period to break the stranglehold of inflation – or even the period before the Great Recession, when inflation averaged 2.4%, which exceeds the Fed’s 2% target – climbing prices just aren’t a problem now. And unlike before the last recession, the housing market hasn’t overheated. There’s no mortgage bubble. Quite the opposite, housing is actually struggling (partially the result of adverse tax changes and rising mortgage rates).

But overall, nothing really serious is out there that would indicate the next recession will be a bad one. If we do go into recession this year, it likely will be relatively short and shallow. That’s because investors are not the only ones scared of such a risk, the Fed is nervous about it as well. The prospect of growth slipping below 1% – let alone a recession – should prompt the Fed to cut rates and/or restart the quantitative easing (QE) machine again.

So that’s the playbook should we face a recession in the near term. But while the risks have clearly increased, I am not currently forecasting such a slowdown in the next two years. I expect the US economy to grow at a 2.5% pace this year, ticking down to 2% in 2020.

In fact, after such a pause, it’s more likely we see a growth rebound beyond 2020 than a recession. Why? Because, while every recession is ultimately caused by the Fed raising rates too much, the Fed’s policymakers also have the power to restart the economic engine by pausing their monetary tightening at the right time and possibly adding a little boost with a well-timed rate cut.

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