The Trigger Of The Next Recession

This article appeared in the latest In Gold We Trust report from Incrementum Liechtenstein:

Will there soon be a recession in the US? The track record of economists with respect to timely forecasts of recessions is not much to write home about. This is partly due to the fact that most economists don’t take recession probabilities sufficiently into account in their stochastic equilibrium models, and that they are generally subject to an “optimism bias”.

However, even if an economist expects a recession, forecasting its timing is practically impossible in view of the complexity of all the causal interrelations. Due to the non-linear inter-dependencies in a dynamic system, small causes can have large effects. In the course of a presentation on the predictability of the weather, meteorologist Edward N. Lorenz once asked “Does the Flap of a Butterfly’s Wings in Brazil Set Off a Tornado in Texas?” We are asking: could a bursting bubble in China, a Greek exit from the euro zone, Brexit, a failing Italian bank or maybe just a major loss at Deutsche Bank trigger a global economic crisis? Maybe it won’t take more than a verbal lapse by Janet Yellen?

gold_price_recessions

Due to the never before seen density of economic interrelations, the relevance of such causal connections for the global economy is greater than ever. We believe that precise forecasts of recessions, especially predictions of when they will begin and how long they will last are hocus-pocus. Instead we have pointed to developments above, which document the system’s fragility and suggest a growing likelihood of a recession striking in the near future. Our focus has been on the US economy, as it is still the largest economy in the world. Moreover, the US dollar is the global reserve currency and the Fed’s decisions therefore strongly influence the global economy as well as global monetary policy. However, above all, the US economy is regarded as the model for pro-active economic interventionism and its performance is therefore very important for maintaining the current economic worldview.

Inter-dependencies naturally imply effects flowing in two directions: Numerous events could potentially trigger a recession in the US – including recessions in other parts of the world. There are the eternally shaky prospects of Japan; there are Italy, Canada and Taiwan, all of which are displaying economic weakness; there are large emerging economies such as Brazil and Russia, which are stuck in recession, respectively in stagflation. And there is China, which tries to avert the bursting of a real estate and stock market bubble with all its might, and with respect to which it cannot even be ruled out that in view of its untrustworthy economic data a recession is in reality already underway. In short, there are more than enough trouble spots in the world which could prove contagious for the US economy.

Another trigger could be price inflation, which central banks have tried to revive to no avail for quite some time. Following a sharp decline in commodity prices in recent years, they have recently begun to turn up, which is reflected in recent price inflation data as well. However, that is not all: While the oil price traded in the vicinity of USD 60 between April and June of last year, it was at a lower level over the same time period this year. The oil price started to fall in July of last year though, declining below USD 40 in August, and ultimately closing in on USD 30 as the year progressed.

crude_oil_2015_June_2016

Ceteris paribus the oil price will begin to affect inflation rates from July onward due to base effects. Should the oil price remain at the USD 45 level, it would be 17% above last year’s level by year-end, which would boost the inflation rate considerably. This is also illustrated by the chart below. While bond yields are still declining with abandon, the markets could be faced with significant inflation surprises from July onward. Rising inflation rates and falling real interest rates are in our opinion the most important arguments in favor of a rising gold price.

Annual Change in Headline CPI for Various Oil Price Scenarios

inflation_recessions_1960_2015

This has direct effects on the probability of recession as well, as the next chart shows. The tailwind of higher disposable incomes due to lower gas prices could quickly reverse.

CPI_vs_crude_oil_2012_June_2016

Lastly, Fed policy also plays a decisive role with respect to when the inevitable recession begins. Due to the weakness of the US economic expansion we believe that a sustained rate hike cycle scenario is highly unlikely to eventuate. Its implementation would be akin to shooting oneself in the foot. As soon as recession dangers come to the foreground, we expect to see another wave of easing measures instead.

The following five instruments would be available for this purpose:

  • “Forward guidance”: i.e., communication policy, assuring the markets that rate hikes are no longer on the table for the foreseeable future.
  • Rate cuts, possibly even the imposition of negative rates
  • Another quantitative easing program (possibly an expanded version including the purchase of  corporate bonds and/or stocks)
  • Helicopter money
  • And theoretically: open market operations involving gold purchases (a deliberate devaluation of the dollar vs. gold).

The measure that would be most easy to implement would be a change in the Fed’s communication policy. It could for instance refrain from further rate hikes for the time being, and communicate this fact to the markets. However, we assume that the Fed wants to avoid, at all cost, reversing its monetary policy stance in the middle of the presidential election campaign. Furthermore, the debate over economic stimulus has recently increasingly shifted toward fiscal policy. The currently prevailing narrative of a putative rate hike cycle will be maintained as long as possible. What is certain is this: Once the feared recession arrives, the adoption of further monetary and fiscal policy measures is as sure as night follows day.

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