Friday, June 30, 2017

From What Direction is the Next Recession Coming?

If you were learning about the causes of post-World War II US recessions 20 years ago, the standard chain of events went like this: As the economy goes into an upswing, wage and price inflation starts to rise. The Federal Reserve recognizes that rising inflation isn't a sign of healthy growth, and raises interest rates. In often-used phrase, it's the job of the Federal Reserve to order that "the punch bowl removed just when the party was really warming up." The higher interest rates dampen inflation, but also lead to recession. The clear implication from this earlier line of thought is that recessions don't occur just because a recovery has gone on for a long time: instead, recessions are caused when the Fed decides to dampen inflation. For example, here's eminent economist Rudiger Dornbusch (and co-author of one of the preeminent macroeconomics textbooks of the time) writing back in 1997:
"No postwar recovery has died in bed of old age--the Federal Reserve has murdered every one of them. The typical pattern is that a few years into a recovery, as unemployment drops and the labor and product markets tighten, wage and price inflation picks up, the wage-price spiral gets moving, and soon the Fed steps in to douse wage demands with a good old-fashioned recession. And the whole cycle starts all over again."
But the last few recessions haven't really followed this narrative. Sure, you can see just a little belch of inflation circa 2007, but the Great Recession was at its root a financial crises tracing back to financialization of mortgage securities and a boom-and-bust in housing prices. Similarly, you can see a little burp of inflation back around 2000, but the recession of 2000-2001 was about the end of the dot-com boom, with a drop in the stock market and an accompanying fall in real investment. Even going back to the 1990-91 recession, there is again a small hop in inflation beforehand, that recession was also related to a boom-and-bust in certain regional housing markets and linked to the widespread failures across the saving-and-loan industry.

In short, the old story of recessions caused by fighting back against a rise in inflation seems outdated. Instead, a number of recent recessions seem to be more fundamentally caused by financial crises. A similar point can be made about other recessions around the world: for example, the recessions in the east Asian financial crisis of 1997-98 or the recession across the euro area in 2011-12 were driven by interactions between exchange rates, international capital movements, and the financial sector, not by fighting off inflation.  I found myself mulling over this shift while reading the 87th Annual Report of the Bank of International Settlements s (released June 25, 2017).

As the report spends a couple of chapters discussing, the current and near-term prospects for the global economy are the best they have been for at least a decade. For example, the US unemployment rate had fallen to  4.3% in May, and has now been 5% or lower since September 2015. Thus, the report looks to the middle-term risks:
"The Report evaluates four risks – geopolitical ones aside – that could undermine the sustainability of the upswing. First, a significant rise in inflation could choke the expansion by forcing central banks to tighten policy more than expected. This typical postwar scenario moved into focus last year, even in the absence of any evidence of a resurgence of inflation. Second, and less appreciated, serious financial stress could materialise as financial cycles mature if their contraction phase were to turn into a more serious bust. This is what happened most spectacularly with the Great Financial Crisis (GFC). Third, short of serious financial stress, consumption might weaken under the weight of debt, and investment might fail to take over as the main growth engine. There is evidence that consumption-led growth is less durable, not least because it fails to generate sufficient increases in productive capital. Finally, a rise in protectionism could challenge the open global economic order. History shows that trade tensions can sap the global economy’s strength." 
But inflation in the US and other high-income countries has been so quiet for the last 25 years that it has puzzled economists, including Fed Chair Janet Yellen.  The BIS report notes (references to chapters and graphs omitted):

"[A] substantial and lasting flare-up of inflation does not seem likely. The link between economic slack and price inflation has proved rather elusive for quite some time now. To be sure, the corresponding link between labour market slack and wage inflation appears to be more reliable. Even so, there is evidence that its strength has declined over time, consistent with the loss of labour’s “pricing” power captured by labour market indicators. And, in turn, the link between increases in unit labour costs and price inflation has been surprisingly weak. The deeper reasons for these developments are not well understood. One possibility is that they reflect central banks’ greater inflation-fighting credibility. Another is that they mainly mirror more secular disinflationary pressures associated with globalisation and the entry of low-cost producers into the global trading system, not least China and former communist countries. Alongside technological pressures, these developments have arguably sapped both the bargaining power of labour and the pricing power of firms, making the wage-price spirals of the past less likely. These arguments suggest that, while an inflation spurt cannot be excluded, it may not be the main factor threatening the expansion, at least in the near term. Judging from what is priced in financial assets, also financial market participants appear to hold this view."
Given the good news of weak inflation, it seems plausible that the next recession will arise out during the next financial crisis. At least right now, such a crisis seems most likely to arise outside of the US and European economies. Instead, there are some troubling signs of excessive debt and financial strain in some emerging market economies, as well as in Canada. The BIS report notes:
"The main cause of the next recession will perhaps resemble more closely that of the latest one – a financial cycle bust. In fact, the recessions in the early 1990s in a number of advanced economies, without approaching the depth and breadth of the latest one, had already begun to exhibit similar features: they had been preceded by outsize increases in credit and property prices, which collapsed once monetary policy started to tighten, leading to financial and banking strains. And for EMEs [emerging market economies], financial crises linked to financial cycle busts have been quite prominent, often triggered or amplified by the loss of external funding; recall, for instance, the Asian crisis some 20 years ago. ...
"Admittedly, such risks are not apparent in the countries at the core of the GFC [global financial crisis], where domestic financial booms collapsed, such as the United States, the United Kingdom or Spain. ... Rather, the classical signs of financial cycle risks are apparent in several countries largely spared by the GFC, which saw financial expansions gather pace in its aftermath. ...
"Financial cycles have been a key determinant of macroeconomic dynamics and financial stability. Peaks in the financial cycle have tended to signal subsequent periods of banking or financial stress. From this perspective, ongoing or prospective financial cycle downturns in some EMEs and smaller advanced economies pose a risk to the outlook. Such risks can be assessed through early warning indicators of financial distress. One such indicator is the credit-to-GDP gap, defined as the deviation of the private non-financial sector credit-to-GDP ratio from its long-term trend. Another is the debt service ratio (DSR), ie the same sector’s principal and interest payments in relation to income, measured as deviation from the historical average. These indicators have often successfully captured financial overheating and signalled banking distress over medium-term horizons in the past. ... 
"Standard metrics, such as credit-to-GDP gaps, signal financial stability risks in a number of EMEs, including China and other parts of emerging Asia. Gaps are also elevated in some advanced economies, such as Canada, where problems at a large mortgage lender and the credit rating downgrade of six of the country’s major banks highlighted risks related to rising consumer debt and high property valuations. ... Financial cycles in this group are at different stages. In some cases, such as China, the booms are continuing and maturing; in others, such as Brazil, they have already turned to bust and recessions have occurred, although without ushering in a full-blown financial crisis." 

An interrelated problem here is that a lot of the borrowing in the world happens with financial instruments that involve US dollars. When an economy outside the US has large US-dollar denominated debts (whether these debts are private or public sector), that economy is vulnerable to a shift in exchange rates that make it harder to repay such debts, or to a change in financial conditions that makes it harder or more costly to roll over the US-dollar denominated debt.  The BIS writes:
"EMEs face an additional challenge: the comparatively large amount of FX [foreign exchange] debt, mainly in US dollars. Dollar debt has typically played a critical role in EME financial crises in the past, either as a trigger, such as when gross dollar-denominated capital flows reversed, or as an amplifier. The conjunction of a domestic currency depreciation and higher US dollar interest rates can be poisonous in the presence of large currency mismatches. From 2009 to end-2016, US dollar credit to non-banks located outside the United States – a bellwether BIS indicator of global liquidity – soared by around 50% to some $10.5 trillion; for those in EMEs alone, it more than doubled, to $3.6 trillion. ...

"The patterns highlighted above suggest that global US dollar funding markets are likely to be a key pressure point during any future market stress episode. Non-US entities’ US dollar funding needs remain large, posing potentially sizeable rollover risks. They are also concentrated on a rather limited number of major banks. Interconnectedness is another important factor, as dollar funds are sourced from a variety of bank and non-bank counterparties to support both outright US dollar lending and various types of market-based dollar intermediation. In this context, counterparties such as MMMFs [money market mutual funds], insurance companies and large corporates interact with banks in a range of markets, including those for repos and FX swaps. In addition, many of the same banks provide services to entities such as CCPs [central counterparties], which – under stress – can be a source of large liquidity demands."
Of course, pointing to some potential economic danger signs a few years off in the future is not a forecast that another crisis will actually occur. My point is that when we worry about potential causes of the next recession and changes in central bank policy, including Federal Reserve policy, we should be paying a lot less attention to risks of inflation--which seems to be in a coma, if not actually dead and buried--and a lot more attention to risks of financial overheating as they arise around the world.