At the beginning of 2019, many pundits saw signs that the economy was in danger of entering a recession. Indeed, 2019 has seen the sorts of problems that in the past would have triggered a slump, including a trade war and declining investment. So why hasn’t it already happened?
If the Federal Reserve had not recently changed its approach to monetary policy, the economy might well have already slipped into contraction. Fortunately, the Fed is gradually moving toward a new and more nimble policy regime, which relies more heavily on asset prices to guide policy. This should make recessions less frequent. Nonetheless, the transition to a more market-oriented policy is not complete, and there is still an unnecessarily high risk of recession in 2020.
The global economy is a highly complex system that no computer model can simulate. While markets are far from perfect, asset prices do incorporate information from millions of individuals, each of which observes a tiny sliver of the economy. Financial markets tend to signal economic trouble ahead long before computer models that rely on past economic data, collected methodically by government bureaucracies.
Case in point: In the past, the Fed often used a Phillips curve model as a guide to policymaking. According to this theory, inflation is caused by a tight labor market with a low unemployment rate — specifically, one below the “natural rate,” which measures job seekers who are unemployed even in a healthy economy (like new graduates or people changing careers).
Last December this theory led the Fed to anticipate several interest rate increases in 2019. As recently as July, prominent economists such as Robert Shiller were suggesting that the very low unemployment rate called for a higher interest rate target.
Unfortunately, the Phillips curve model is not reliable, mostly because it is almost impossible to know the current natural rate of unemployment, which can only be estimated in retrospect. In late 2018, investors who understood the unreliability of the Phillips curve showed increasing concern that further rate hikes could push the economy into recession. Interest rate futures markets began predicting that the Fed would actually be forced to reduce rates during 2019, which of course is exactly what happened.
In the past, when an economic shock such as the U.S.-China trade war led to more bearish expectations, the Fed was often too slow to respond. Thus, as a severe recession was developing in 2008, the Fed did not cut interest rates even once between April and October. It was focused on past inflation data, not real-time financial market warnings of a slowdown ahead.
More recently, the Fed seems to be learning from past mistakes. It is now relying more heavily on the financial markets as an indicator of the future path of the economy. As a result of the Fed’s decision to abandon its 2019 rate increases and do the opposite (despite historically low peacetime unemployment), we are now in the 11th year of an economic expansion, a new record.
There is no time limit on economic expansions. Britain had a 16-year expansion from 1992 to 2008, and Australia is in the midst of a 28-year expansion. And yet prior to 2019, America had never gone more than 10 years without a recession. This is because monetary policy was not sufficiently forward looking. The Fed simply relied too much on past economic data, like steering a car by looking in the rearview mirror.
Even with the Fed increasingly willing to use the information contained in asset prices to anticipate future problems, the financial markets continue to suggest that the Fed needs to take further steps to prevent a recession. Monetary policy is still a bit too tight. Moreover, many long-term interest rates remain lower than short-term rates, which is traditionally a warning sign of recession. Thus the Fed cannot rest on its laurels; further interest rate cuts are needed.
Market monetarists like myself advocate a monetary policy that is guided by market forecasts. The basic idea is that if the Fed’s goal is 2 percent inflation, then interest rates should be set at a level where the consensus market forecast settles at 2 percent inflation. Markets are not always correct, but when the Fed ignores strong market signals that its policy is off course, the outcome is usually disappointing.
Fortunately, the Fed is beginning to learn its lesson. Let’s hope it continues to move in this direction.
Scott Sumner is an emeritus professor of economics at Bentley University and the Ralph G. Hawtrey chair of monetary policy at the Mercatus Center at George Mason University.