Calculated Risk: Expect the Next Recession

In a 2013 post, she wrote:

The cause of the following stagnation is likely to be one of the following (from least likely to most likely):

3) An external event such as an epidemic, major military conflict, interruption in energy supply for any reason, major natural disaster (meteor strike, giant volcano, etc.), and a number of other reasons with low probability. All of these events are possible, but they are unpredictable, and the odds of them happening are low in the next few years or even decades.
Confirmations added

Unfortunately, in 2020, one of those low-probability events (pandemic), and that led to a recession in 2020.

2) A big policy mistake. Two examples: no fiscal deal and exit from the “fiscal cliff” would have led to a recession, and Congress’ refusal to “pay the bills” would have constituted a policy error that would have sent the economy into a recession.

We saw many errors in policy, mostly related to immigration and trade, during the previous administration, but none that would lead the economy into recession.

1) Most of the post-World War II recessions were due to The Federal Reserve tightens monetary policy to slow inflation. I think this is the most likely cause of the upcoming recession. Usually, when inflation begins to become a concern, the Fed attempts to engineer a “soft landing”, often with a recession.

And the This is the most common cause of stagnation is current anxiety. Since inflation has recovered, mostly due to the pandemic (stimulus spending, supply constraints) and due to the invasion of Ukraine, the Fed has embarked on a tightening cycle to slow inflation.

The Fed cannot ease the supply constraints associated with the pandemic (except by curbing demand), and the Fed cannot stop the war. Therefore, there is a possibility that the Fed will tighten too much and this will lead to a “hard landing” (aka a recession).

The key will be to view the housing. Housing is the main transmission mechanism of Fed policy. One of my favorite models to forecast the business cycle uses new home sales (also new homes and residential investment). I also look at the yield curve, but I’ve found new home sales to be more beneficial overall. (See my post in 2019: Stay tuned for the yield curve)

As for the economy, what I focus on are single-family beginnings and new home sales. For the bottoms and peaks of primary housing activity, here is a graph of single-family housing starts, new home sales, and residential investment (RI) as a percentage of GDP.

Note: The pandemic has distorted economic data, and as I have pointed out many times, We can’t be a slave to any model.

Click on the chart for a larger picture.

The arrows point to some of the previous – and most recent – peaks and troughs of these three metrics.

The purpose of this chart is to show that these three indicators generally hit both tops and bottoms. Note that residential investment is quarterly, single-family starts, and new home sales are monthly.

Sales of new homes and single-family starts have fallen in the past year, but that’s partly because sales have skyrocketed during the pandemic — and then rebounded somewhat. Now both new home sales and single family start-ups have plummeted in response to high mortgage rates. Residential investment has also reached its peak.

New home sales change year on yearThe second chart shows the annual change in new home sales from the Census Bureau. New home sales are currently down (on a 3-month average basis) by 10% year over year.

Note: New home sales data is smoothed using the . file Average three months Before calculating the annual change. Census Bureau data begins in 1963.

some notes:

1) When the annual change in new home sales decreases by 20%, a recession usually follows. The exception to this series of data was the mid-1960s when growth in Vietnam kept the economy from stagnating. There was another exception in late 2021 – we saw a significant year-on-year decline in new home sales linked to the pandemic and an increase in new home sales in the second half of 2020. I ignored this epidemic distortion.

Note also that the sharp decline in 2010 was related to the housing tax credit policy in 2009 – and it was merely a continuation of the housing slump.

2) It’s also interesting to look back at the ’86/’ and mid ’90s. New home sales fell in both periods, though not 20%. As I noted in earlier publications, the mid-1980s saw a rise in defense spending and the Ministry of Electricity and Water that compensated for the decline in new home sales. In the mid-1990s, non-residential investment remained strong.

If the Fed’s tightening cycle leads to a recession, we will see housing decline first (new home sales, single family start-ups, housing investment). This is happening nowbut that usually drives the economy for a year or more. So, maybe we’re looking at a recession in 2023.

There are other indicators as well – like the yield curve and heavy truck sales – but mostly I’ll be watching housing.

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