the money game

Warning: Recession Ahead

The Fed made the economy weird, and now no one knows exactly when it’s going to crash

Photo-Illustration: Intelligencer; Photos: Shutterstock
Photo-Illustration: Intelligencer; Photos: Shutterstock

Last month, Federal Reserve chair Jerome Powell convened a two-day meeting in Washington, D.C., with the seven other central-bank governors, plus nearly 100 economists and researchers, to officially end the policies that had kept the economy propped up during the pandemic. At the end of the meeting, the Fed did what it had been expected to do and raised interest rates by a quarter of a percentage point — not much, but a clear start to a regime that would slow the economy and, presumably, tamp down on the highest inflation rate in 40 years.

What wasn’t known beyond those 100 or so people until Wednesday, however, was how the Fed was planning to go further than that and faster than had ever been done before in order to slow borrowing, spending, and hiring from rising so much that they send prices spiraling out of control. The central bank announced it would start selling off the $5 trillion in debt it had bought up during the pandemic at a rate of about $1.1 trillion a year, possibly more. It’s a move that is little understood by economists but could happen as soon as next month — and could raise the odds that the economy tilts into a recession.

Despite what you may believe, the U.S. economy is not in a recession right now. It might not feel that way — I just paid $4.27 a gallon for regular gas in New Jersey, where it’s supposed to cheap — but the dissonance of rising wages and employment with even steeper price hikes has set off a parlor game on Wall Street and among economists to try to gauge when the economy will contract. Earlier this week, Deutsche Bank became the first big bank to make a call that a recession would happen in the next two years. Goldman Sachs made a similar, if more hedged, prediction. These prognostications all came before the Fed revealed it would be pumping risk back into the markets at an unprecedented pace.

The recession watch really started in earnest last week, when something strange happened in the markets. For a brief moment, the U.S. government was paying less to borrow money for a longer period of time — in this case, ten years — than it would for two years. (Typically, debts that take longer to pay back are more expensive because of the risk that the lender will lose money). In the parlance of Wall Street, this is called a “yield-curve inversion.” But in the minds of investors, this is telling a story that goes something like this: The Fed, which is hell bent on raising interest rates, is going to hike aggressively for the next two years or so until it forces the economy into a recession. After that, it will have to reverse course, lower borrowing costs and perhaps take other measures to drain the amount of financial risk in the system.

More importantly, on Wall Street, the yield curve’s inversion is a phenomenon that in the past has happened to predict the likelihood of a recession in the next 18 months or so and is taken very seriously as a sign of bad things to come. But it’s not a perfect signal, either. There are plenty of people who are skeptical that it will apply to the pandemic economy warped by $5 trillion in stimulus, a snarled global supply chain, war in Ukraine, and the vast numbers of high-wage earners working from home. “It’s a better predictor than any economist of a recession, but it doesn’t have a significant sample size. There have been eight recessions that a yield-curve inversion has predicted, and that’s not a huge amount,” said Megan Greene, the global chief economist at the Kroll Institute and a senior fellow at Harvard’s Kennedy School.

But there are other ways to suss out if a recession is coming — some less known than others. Greene recommended following the Sahm Rule, an indicator that says the economy is in a recession when the average rate of unemployment rises by half a percentage point above its low point from the last 12 months. I reached out to the former Fed economist who developed that measure, Claudia Sahm, who is now head of the Macroeconomic Research Initiative of the Jain Family Institute, but even she wasn’t sure that it should apply. “I’m not even sure that song ‘we’re going above a half a percentage point’ is gonna be a recession because the economy is really in a baffling, disrupted state,” she told me.

Sahm spoke to me about an hour after the Fed’s March meeting minutes were released and said one of the risks about the Fed’s plans to tighten up the economy is just how little things can be predicted. The last time the central bank dumped debt back into the markets, from 2017 to 2019, it did so at about $30 billion to $45 billion a month — about one-third to one-half the rate that it’s planning now. She and Greene both noted that it’s not really well understood how the Fed’s bond-selling program can change the markets, and it could potentially be more disruptive than just making it harder or more expensive to borrow. “They have to be careful that they’re not causing instability in those markets,” Sahm said.

There is only so much that the Fed can do, considering how the problems with the economy — like high gas prices and slow shipping — are outside any single official’s hands. “Policy-makers in the United States can do a good job getting demand going, but they can’t put vaccines in arms, they can’t go and load the docks in China,” Sahm said. “The Fed has no ability through interest rates — unless they would cause a very severe recession, and even then, it’s questionable — to bring gas prices down, to bring food prices down. Those are necessities. You might cut back on other things, but people have to get to work, they have to do what they do.”

Warning: Recession Ahead