Calculated Risk: Recession Watch
The next recession will probably be caused by one of the following (from least likely to most likely):
3) An exogenous event such as a pandemic, significant military conflict, disruption of energy supplies for any reason, a major natural disaster (meteor strike, super volcano, etc), and a number of other low probability reasons. All of these events are possible, but they are unpredictable, and the probabilities are low that they will happen in the next few years or even decades.
Unfortunately, in 2020, one of those low probability events happened (pandemic), and that led to a recession in 2020.
2) Significant policy error. Two examples: not reaching a fiscal agreement and going off the “fiscal cliff” probably would have led to a recession, and Congress refusing to “pay the bills” would have been a policy error that would have taken the economy into recession.
Refusing to “pay the bills” (not raising the debt ceiling), would be a policy error – but that seems unlikely (you never know).
1) Most of the post-WWII recessions were caused by the Fed tightening monetary policy to slow inflation. I think this is the most likely cause of the next recession. Usually, when inflation starts to become a concern, the Fed tries to engineer a “soft landing”, and frequently the result is a recession.
And this most common cause of a recession is the current concern. Since inflation picked up, mostly due to the pandemic (stimulus spending, supply constraints, WFH impacts on household formation) and due to the invasion of Ukraine, the Fed has embarked on a tightening cycle to slow inflation.
The Fed cannot ease pandemic related supply constraints (except by curbing demand), and the Fed cannot stop the war. So, there is a possibility that the Fed will tighten too much and that will lead to a “hard landing” (aka recession).
For the economy, what I focus on is single family starts and new home sales. For the bottoms and tops of key housing activity, here is a graph of Single-family housing starts, New Home Sales, and Residential Investment (RI) as a percent of GDP.
Note: The pandemic has distorted the economic data, and as I’ve noted many times, we can’t be a slave to any model.
Click on graph for larger image.
The arrows point to some of the earlier peaks and troughs for these three measures – and the most recent peak.
The purpose of this graph is to show that these three indicators generally reach peaks and troughs together. Note that Residential Investment is quarterly and single-family starts and new home sales are monthly.
New home sales and single-family starts turned down last year, but that was partly due to the huge surge in sales during the pandemic – and then rebounded somewhat. Now both new home sales and single-family starts have turned down in response to higher mortgage rates. Residential investment has also peaked.
The second graph shows the YoY change in New Home Sales from the Census Bureau. Currently new home sales (based on 3-month average) are down 13% year-over-year.
Note: the New Home Sales data is smoothed using a three month centered average before calculating the YoY change. The Census Bureau data starts in 1963.
1) When the YoY change in New Home Sales falls about 20%, usually a recession will follow. An exception for this data series was the mid ’60s when the Vietnam buildup kept the economy out of recession. Another exception was in late 2021 – we saw a significant YoY decline in new home sales related to the pandemic and the surge in new home sales in the second half of 2020. I ignored that pandemic distortion.
2) It is also interesting to look at the ’86/’87 and the mid ’90s periods. New Home sales fell in both of these periods, although not quite 20%. As I noted in earlier posts, the mid ’80s saw a surge in defense spending and MEW that more than offset the decline in New Home sales. In the mid ’90s, nonresidential investment remained strong.
If the Fed tightening cycle will lead to a recession, we should see housing turn down first (new home sales, single family starts, residential investment). This has happened, but this usually leads the economy by a year or more. So, we might be looking at a recession in 2023.