The Hankyoreh, January 13, 2019
With the New Year and the US recovery soon to be record-breaking in duration, many are asking when the next recession is likely to come and what will cause it. While none of us has a crystal ball that gives a clear view of the future, there are a few things we can say.
First, and most importantly, the next recession will not look like the last recession. The last recession was caused by the collapse of a massive housing bubble that had been the driving force in the previous recovery. While economists like to pretend this was an unforeseeable event, that is not true.
There was an unprecedented run-up in nationwide house prices. It was clear that this was not being driven by the fundamentals of the housing market, as there was no remotely corresponding increase in rents, and vacancy rates were hitting record levels.
Furthermore, it was easy to see the housing bubble was driving the economy. Residential construction was hitting record shares of GDP, more than two full percentage points above its long-term average of 4.0 percent of GDP.
The wealth created by the bubble was also leading to a consumption boom, as people spent based on the new equity created by the run-up in the price of their home. This was also easy to see in the data, as the ratio of consumption-to-income hit record levels.
This history is important to review because many analysts are looking for the next recession to be a replay of the 2008 crash. If we pretend that the bursting of the housing bubble and subsequent downturn was an unforeseeable event, then there could be other unforeseen events that will sink the economy. For this reason, it is necessary to point out that the 2008 collapse was entirely foreseeable, economists just ignored the evidence that was visible to anyone who examined the economy with open eyes.
If we rule out the collapsing bubble as the story for the next recession, we are left with the standard story that explains every recession since the end of World War II and before 2001. The Federal Reserve Board raises interest rates too high in an effort to head off inflation. While this chain of events is not likely to trigger a recession in 2019, it is certainly plausible that it will play out in 2020.
While wage growth has been sluggish following the Great Recession, the tighter labor market is finally giving workers more bargaining power. The year-over-year rate of increase in the average hourly wage (the most commonly used measure) was 3.2 percent in the December data. That is up from a 2.5 percent rate in 2017. If we take the annual rate for the most recent three months compared with the prior three months, it is slightly faster at 3.3 percent.
This pace of wage increases is not terribly fast, but it does seem likely that the pace will continue to accelerate if the labor market stays tight. The rate of productivity growth has remained very weak in this recovery at just over 1.0 percent.
Productivity growth acts as an offset to wage growth. If productivity growth were equal to growth (3.2 percent in the most recent data) then employers are seeing no increase in their labor costs per unit of output.
However, in a context where wage growth is 3.2 percent and productivity growth is just 1.0 percent, labor costs per unit of output are rising at a 2.2 percent rate. If wage growth accelerates with no corresponding increase in productivity, then labor cost per unit of output will be rising more rapidly.
Higher labor costs will not be passed on directly in higher prices. Conditions of competition will likely limit firms’ ability to raise prices. This means profits may be reduced to some extent. This is perfectly reasonable, since there was a large increase in profits at the expense of workers in the Great Recession.
However, at some point it is likely that higher labor costs will lead firms to raise their prices more rapidly. If the Fed is committed to maintaining its target of a 2.0 percent average inflation rate, it will find it as necessary to raise interest rates to increase the unemployment rate and reduce workers’ ability to secure pay increases. While it surely does not want to induce a recession with higher rates, the history suggests that this is a likely outcome.
Again, this is not a story that is likely to play out in 2019. The inflation rate remains under 2.0 percent using the core personal consumption expenditure deflator, which is the key measure for the Fed. However, if wage growth does continue to pick up in the next few months, then we are likely to see a somewhat higher inflation rate in the near future.
That could trigger more aggressive rate hikes by the Fed. Given the lag between increases in interest rates and their impact on the economy, Fed rate hikes in the middle of 2019 will not lead to a recession in 2019, but they certainly could in 2020.
That would be my best guess as to what the next recession looks like and when it will come. There can always be extraneous factors that would hugely change the picture. For example, if a war or revolution lead to large disruptions of oil flows and therefore sharp price rises. It is also possible that Trump’s trade wars get completely out of control and go from being minor drags on the economy to major disruptions.
But, barring these sorts of unpredictable events, I would go with a Fed-induced recession in 2020.