Update 350 — Fed Stability Report and the Perils of Prediction, Cycles, and Psychology
On Monday, the Federal Reserve released its latest assessment of risks to the financial system in its biannual Financial Stability Report. The Report mainly focused on the increase in high risk corporate debt — or leveraged loans (see last week’s update).
The Report comes amid a macroeconomic backdrop of robust economic numbers, subdued inflation, and a low unemployment rate. But it does not evaluate risks to financial stability stemming from market cycles and psychology. Asked to pinpoint the single biggest threat to the U.S. economy at a House Financial Services hearing last month, Citigroup CEO Michael Corbat answered, “Our ability to talk ourselves into the next recession.”
We examine the possibility of a self-fulfilling prophecy recession, below.
Fed Stability Report: Measurable Risk
In its second-ever financial stability report, the Fed assessed quantifiable risk factors that could threaten financial stability and/or portend the next recession. It cited elevated business leverage of deteriorating quality. Per the Report, “borrowing by business is historically high,” with leveraged lending up 20 percent in 2018 to $1.1 trillion.
The Fed also pointed out that risks associated with leveraged loans have “intensified, as a greater proportion are to borrowers with lower credit ratings and already high levels of debt.” It found that asset valuations are elevated relative to historical ranges, with investors’ current “high appetite” for risk.
The Report noted low leverage in the financial sector. Banks are well positioned with capital and liquidity reserves, thanks to post-crisis regulations. The Report also described funding risks in the financial system as low, suggesting that banks will be less susceptible to the dangerous runs experienced during the financial crisis.
Mixed Macro Picture
Per the Report, macroeconomic indicators for the US economy are mixed:
- Retail sales: Down in February, but recovered in March.
- Construction spending: Up 2.5 percent in January and by around 1 percent in February — an indicator of strength.
- Housing: This market remains soft. Year to date, new home sales are higher than the same period in 2018, but barely: 1.7 percent.
- Labor market: Continues to be strong, with the economy adding 263,000 jobs in April and unemployment at a 49-year low of 3.6 percent.
- Economic growth: GDP rose by 3.1 percent in the first quarter of 2019, beating expectations and up from 2.6 percent in the fourth quarter of 2018.
The tax cut stimulus effect is waning, with White House economist predictions deviating markedly from Federal Reserve and Congressional Budget Office projections for annual GDP in 2019. With inflation still under target, there will likely not be any monetary tightening in the near future, but that will leave the Fed with little room to maneuver in the event of a downturn.
Stability Report Omissions
Besides the risks identified in the Fed Stability Report, other phenomena in the last six months indicate that a recession could be on the horizon. We are now in the 116th month of the current expansion. This expansion is double the post-WWII norm and five months from becoming the longest on record. Several indicators that peak before recessions — retail sales, industrial production, and unemployment rate — are at their highest rates since 2000. The historically high ratio between household wealth and income is another less-discussed indicator, the two previous peaks of which preceded recessions.
The biggest omitted omen from the Fed Stability Report, though, is the yield curve inversion. After a worrisome flattening following market instability in late 2018, then an inversion this past March, the 10-year rate fell 2.5 basis points to around 2.44 percent on Tuesday.
This new flattening indicates investor uncertainty as long-term debt begins to yield less than short-term debt. The curve inversion doesn’t guarantee a recession, nor does it indicate how far off a downturn may be. Grouped with other concerning indicators, however, as well as increased risk in the leveraged loans market, stormy skies could be just out of sight.
Source: New York Fed
Animal Spirits vs. the Canaries
Declining consumer confidence — a measure of how the public is feeling about the economy — is widely viewed as a leading indicator of an impending downturn. High levels of consumer confidence correlate with overall economic expansion, increased household spending, lower savings rates, and low unemployment rates. Dips in consumer confidence are thus concerning.
Others argue that consumer confidence is a lagging indicator, in that it is determined by the business cycle, rather than the other way around. Regardless, consumer confidence is worth examining, as experts and pundits are now concerned that we might be at risk of “talking ourselves into a recession.”
Those arguing that dips in consumer confidence don’t imply recessions say that consumer attitudes are slower to adjust to macroeconomic risks than other areas of the economy, such as the stock market. Though this makes intuitively sense — changing peoples’ attitudes requires new information and time — noneconomic factors also alter consumer confidence and spending behavior, with eventual macro impact. The administration has contributed to stock market volatility, so fears of self-inflicted damage may be warranted.
Ideologically diverse economists tend to agree on this: recessions are nearly impossible to predict. Many economists and policymakers did not predict the last recession, particularly the cause. Though high-risk corporate debt, specifically the leveraged loans market, is drawing regulatory attention, it may not be a harbinger of the next recession. With investors’ “high appetite” for risk, there may be an unknown systemic problem, lurking in the shadows. Fiscal stimulus is dissipating and there is little room for monetary policy in the event of a crisis — so the only question is not really if, or how, but when and how bad?