It's All About the Lags

Either the financial community is replete with neophytes with no experience that have never lived through an entire business cycle, or people with extremely short memories.

The column that appeared in Wednesday of last week's New York Times (page B3) titled Wall Street’s Recession Warning Is Flashing, but Some Wonder if it’s Wrong made me laugh. The article is all about the alleged head fake being provided by the inverted yield curve. I said when the Fed first started hiking rates in March 2022 that if it inverted the Treasury curve, every Tom, Dick, and Harry economist would be telling the masses to ignore the recession message. The fact that Fed-induced curve inversions have presaged recessions 100% of the time in the past is never respected. Always a case of hope triumphing over experience. Thing is — very rarely do recessions occur in the same month as the onset of the inverted yield curve. There are lags, and that typically can be a year or longer. Think back to 2007. But like the story of the boy who cried wolf, the wolf did show up in the end.

It’s the same deal with the Leading Economic Indicator. It peaked in December 2021 and has declined sequentially for 14 straight months. Again, it leads, and like the yield curve, it is not all that uncommon to have the lag last well over a year. The recession is either here, as per the contraction in real GDI, or it is around the corner.

Lags. Lags. Lags. In the two years before the Fed tightening cycle, real GDP growth has averaged +3.5%. During the Fed tightening cycle, the economy typically expands at its fastest pace of the business expansion, as it feeds off the lagged effects of the prior period of policy accommodation. But look at what happens in the two years after the peak of the Fed tightening. The historical record shows that, without exception, the economy slows down and does so precipitously in the two years that follow the END of the Fed tightening cycle. Not only that but by an average and median haircut to real GDP growth of roughly 3 percentage points. Problem is, the current baseline growth is 1.8% — so the odds we make it through without an outright contraction are next to nil.