February 05, 2016
Neil Irwin had an Upshot piece this morning on the likelihood that the U.S. economy will fall into recession in 2016. He argues that a recession is unlikely, but then gives readers a scenario in which it is possible.
I will say first that I agree that a recession is unlikely. Recessions in the past were brought on by the Fed’s efforts to slow inflation with higher interest rates or by the bursting of an asset bubble.
The Fed’s December rate hike was a mistake, but that is not going to cause a recession. And, few of the members of the Fed’s Open Market Committee are wacky enough to raise rates further in a weak economy with no inflation.
While there may have been bubbles in some sectors of the economy, there was nothing like the $10 trillion bubble in the stock market in the late 1990s or the $8 trillion bubble in the housing market in the last decade. None of the various bubbles were driving the economy, so their collapse will not bring about a recession.
The question then is what could bring a recession. Irwin’s answer is that the continuation of low oil and commodity prices leads to downturns in oil exporting countries and loan defaults by energy producers both domestic and foreign. The hurt to the economy from weaker demand is then compounded by the pessimism of consumers and firms. The former cut back on consumption, while the latter cut back on investment. With the Fed paralyzed by already low interest rates, and also its unwillingness to concede the December rate hike was a mistake, the economy slides into recession.
I see this story as highly unlikely. First, while psychology does matter, there is a tendency to hugely over-rate the size of these effects. For years economists and economic writers were telling us that people were reluctant to consume following the collapse of the housing bubble because they were fearful about their economic prospects.
In fact, there was a much simpler explanation. People had lost trillions of dollars of wealth when the housing bubble burst and the stock market plunged. The “wealth effect,” the idea that people spend based on their wealth, is an economic concept that dates back almost a century. Alan Greenspan frequently touted that people were consuming based on the equity generated by the housing bubble.
Why was it a surprise that they cut back their consumption when this wealth disappeared? The evidence that people are now saving their oil dividend is extremely weak and can easily disappear in subsequent revisions to the data. In short, I don’t see a story where people cut back their consumption in a big way because they hear that Russian economy is in trouble.
There may be a bit more of a story on the investment side, but here too the psychological hit in 2008 was hugely exaggerated. If we pull out structures (there was also a bubble in non-residential investment) Investment actually didn’t fall that much in the downturn and fairly quickly got back to pre-recession levels as a share of GDP. This doesn’t mean that bad vibrations from plummeting oil prices can’t have an impact, just that it is not likely large enough to be recession material.
On the Fed, it is important to note that it is far from out of ammunition. In addition to its conventional control of the short-term interest rate, and its buying of long-term bonds under quantitative easing, the Fed can also go the route of targeting long-term interest rates. Under this policy, which has been pushed by Joe Gagnon, a former Fed economist, the Fed would set a target of say 1.0 percent for the interest rate on 5-year Treasury notes. It would commit itself to buying as many notes as necessary to keep the interest rate at its targeted level.
The Fed has not tried this sort of policy in more than half a century, but there is no legal constraint that prevents it from going this route. Presumably its hesitance is the fear that such a policy could spur inflation.
While it is understandable that the Fed must concern itself with inflation, it is important for the public to recognize that it has policy options to boost the economy and lower unemployment that it has chosen not to use. It is simply wrong to say the Fed is out of ammunition.
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