Recession predictions could become self-fulfilling prophecies

If you woke up tomorrow in an advanced economy growing at 3 percent, with an unemployment rate near a 50-year low, inflation stable around 2 percent and long-term government bond yields below 3 percent, you would probably assume you were in a dream. But, this is no dream, this is the current state of the U.S. economy.

The U.S. economy grew 2.6 percent (annualized) in the final quarter of 2018, bringing average annual growth last year to its highest level in 13 years!

{mosads}Granted that “best economy in over a decade” award requires a wonky appreciation for decimals — GDP growth in 2018 was 2.884 percent while growth in 2015 was 2.881 percent — but there is no doubt economic performance was solid at the end of 2018.

However, despite this goldilocks environment, a specter of pessimism is looming over the U.S. economy. The latest policy survey conducted by the National Association for Business Economics (NABE) showed that over 75 percent of respondents expect a recession by the end of 2021.

And, while only 10 percent of panelists foresee a recession occurring this year, nearly half of the respondents expect the economy to enter a recession by the end of next year.

So, how should one reconcile these worrisome statistics with a seemingly strong U.S. economy? Enter the “recession bias.”

The recession bias is this seemingly unavoidable tendency that markets, economic forecasters, businesses and households display when economic cycles reach a mature age, when economic momentum is turning or when headwinds appear on the horizon.

It’s the inability to see the 50 shades of grey between a 3-percent economy and a recession. In today’s environment, we have all three recession bias triggers in action.

While this recession bias could appear unharmful, it is in fact dangerous. If everyone believes a recession is about to hit the U.S. economy, then most will take measures to protect themselves from this possibility.

This leads households to spend more cautiously, businesses to invest with parsimony, banks to lend more watchfully and investors to trade vigilantly. With everyone on their guard, activity slows, and the self-fulfilling prophecy is fulfilled.

The first recession bias trigger stems from the fact that the economy is rapidly approaching its 120th month of expansion, which will mark the longest economic expansion on record in June of this year.

Along with this anniversary, the myth of duration-based recession has come back to haunt us. Despite numerous efforts to dispel the notion that expansions die of old age, many continue to believe that a long expansion necessarily means a recession is around the corner.

This popular view omits the fact that economic cycles end because of shocks to the system caused, for example, by the Fed tightening too rapidly, oil prices suddenly rising, financial imbalances leading to liquidity concerns or international shocks.

The second trigger for the recession bias comes from the difficulty people have in adapting to changing momentum. For businesses and investors alike, slowing growth after a period of acceleration is generally difficult to digest with ease.

It creates a perception that economic activity is actually much worse than it really is. A good illustration of this comes from the Citigroup Economic Surprise Index, which shows significant swings when growth momentum turns.

With fiscal stimulus dissipating, monetary policy having been tightened and trade tensions weighing on growth, it is not surprising that momentum is turning. However, these factors are not expected to push us into a recession but rather to gradually cool economic activity.

The third trigger for the recession bias comes from the flurry of “crosscurrents,” both domestic and international, that the U.S. is facing. Tightening financial conditions at the end of 2018, slower global growth and lingering uncertainty surrounding Brexit and trade negotiations represent risks to the outlook that have some observers worried about an upcoming recession.

{mossecondads}However, while momentum is turning amid reduced fiscal impetus and numerous crosscurrents, the U.S. economy has a significant growth buffer. Indeed, Oxford Economics foresees the economy slowing from over 3 percent, year-on-year, in the fourth quarter of 2018 to around 2 percent, year-on-year, by the end of this year.

What’s more, with the Fed hitting the pause button on rate hikes and signaling less significant shrinking of its balance sheet, it appears monetary policy may be more of a cushion to growth than previously thought.

And with other global central banks — the Reserve Bank of India, the Bank of England, the Bank of Japan and the European Central Bank — following the Fed’s dovish lead, that cushion should become even fluffier. In other words, a recession doesn’t seem to be lurking around the corner.

Gregory Daco is the chief U.S. economist at Oxford Economics.