Why economist forecasts of a U.S. recession were so wrong

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For the past two years, most economists have predicted a recession in the United States. In fact, this recession was widely expected and did not happen. Like Godot, there were no shows.

This became increasingly clear at the beginning of this year. But while most saved their bleak forecasts for a recession, many predicted that the US Federal Reserve would have to cut interest rates several times to avoid a recession if inflation continues to moderate. This prediction also appears to be wrong, and more economists are now talking about expectations of “higher long-term” interest rates.

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It was reasonable to expect a recession over the past two years. After all, the Fed raised the federal funds rate by 5.25 percentage points between March 2022 and July 2023. It seems certain, it seems, that such a significant tightening in monetary policy would cause something to collapse In the financial system, unleashing a credit crunch that will exacerbate the financial crisis. Cause stagnation. When that happens, the Fed will be forced to cut interest rates quickly. This has been the modus operandi of most monetary policy cycles since the 1960s.

There were plenty of reliable indicators that indicated a recession was coming. The yield curve spread between two- and ten-year US Treasury bonds, which inverted during the summer of 2022, with shorter-term interest rates rising above their longer-term counterparts. It did so just before previous recessions.

The Index of Leading Economic Indicators peaked at a record high during December 2021 and then began to decline from then until April, indicating a recession. The real M2 growth rate – a measure of money supply – year-on-year turned negative during May 2022, and remained negative until March.

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But here's why I think economists were so wrong, and these indicators turned out to be misleading.

Past recessions were mostly caused by credit crises, rising oil prices, or the bursting of speculative bubbles. The inverted yield curve accurately predicted a financial crisis this time, as it had in the past. There was a banking crisis during March 2023, but it did not last long, nor did it cause a credit crunch because the Fed responded quickly by facilitating emergency liquidity to the banking sector.

Oil prices had already risen after Russia's invasion of Ukraine in February 2022, but abundant global supplies and weak global economic growth caused them to fall rapidly. Oil prices rose again during March, as the war between Israel and Hamas showed signs of turning into a regional conflict, but have since declined.

The economy also turned out to be more resilient than economists expected, mostly due to continued growth in consumer spending. Many households benefited from higher interest rates on their bank deposits and money market funds. Many of them also refinanced their mortgages at record low rates during 2020 and 2021.

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More importantly, baby boomers are beginning to retire with a record net worth of $76 trillion. They spend on restaurants, cruises, travel and health care. All of these service industries were expanding salaries, thus boosting real incomes and fueling more spending.

The goods sector of the economy has been experiencing stagnant growth since around March 2021, following the excessive buying that occurred when the lockdown was lifted. However, spending on goods remained at a record high level on an inflation-adjusted basis.

Elsewhere, tight monetary policy has been offset by highly stimulative fiscal policy. The federal deficit has widened due to a lot of federal government spending on infrastructure and federal government incentives to move workers overseas. The federal government's net interest expense soared, pushing personal interest income to a record high.

Corporate earnings and cash flows have also held up very well. Capital spending was not reduced by higher interest rates because many companies raised cash and refinanced when borrowing costs were very low in 2020 and 2021. Capital spending has also been boosted by reshoring as well as a lot of spending on technology hardware, software and research. And evolution. As a result, productivity growth rebounded last year and should remain strong.

What about the index of leading economic indicators? It was not successful because it was too skewed towards the goods economy, which was relatively weak, and did not give enough weight to the services sector, which was strong.

Economists must remember that history does not always repeat itself and is not always consistent. They should rely less on leading indicators and other simplistic models, and more on common sense.

© 2024 Financial Times Limited.

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