The U.S. economy is now in its 11th year of uninterrupted expansion, its longest period on record without a recession. As a result, it’s not surprising that some economists and financial experts predict one may be looming. But there are sound economic reasons to believe the expansion will continue and that a recession, while always a possibility, nonetheless remains unlikely in the year ahead.
Pessimists tend to make several arguments for an imminent recession. One relates to what’s known as the yield curve. When mid- to long-term interest rates fall below short-term rates, as has happened several times in 2019, this tends to be a sign that investors are nervous and less confident than usual to lock themselves in to longer-term investments. A “yield curve inversion” like this tends to happen before recessions. Still, the yield curve is an imprecise predictor and can invert even when no recession is coming. More recently, the Treasury yield curve has returned to normal, suggesting the time of instability may have passed.
Another, simpler argument is that “we are due” for a recession. This constitutes a version of what behavioral psychologists call the “gambler’s fallacy.” Consider a dice thrower who fails to roll a seven on 10 tosses in a row. Does that make him more likely to roll a seven on the next toss? No, because the tosses are independent events. Recessions may be similar; just because there wasn’t a recession in 2019 doesn’t necessarily make the odds of one happening in 2020 any greater.
It may even be that recessions are becoming less likely over time. The last few decades are in some ways a recurring tale of boom followed by bust. A boom in the early 1980s gave way to a stock market crash on “Black Monday” in 1987 and a savings and loan crisis. The 1990s dotcom bubble gave way to the 2001 recession, and the notorious run up of housing prices in the early 2000s was followed by the bust of 2007-08.
And yet, the last decade has been remarkably stable. What changed?
Actually, something very important, yet easy to miss unless you know where to look. A critical 2008 change to monetary policy may be the key to understanding the economic stability we’ve experienced in the last decade.
A little explanation of how monetary policy works shows why this is the case. Prior to 2008, the Federal Reserve — the U.S. central bank — used “open market operations” to influence short-term interest rates through basic supply and demand. In other words, it bought and sold bonds. When it wanted to lower interest rates to stimulate the economy, it bought bonds, and when it wanted to raise rates to keep the economy from overheating, it sold bonds.
These bond sales and purchases had a side effect. Besides influencing interest rates, they changed the size of the “monetary base,” or the amount of reserves plus cash that banks have on hand.
When rates were lowered, banks had more funds available and would increase loans, which would increase the broader U.S. money supply and boost the economy and eventually inflation. When the Fed wanted to raise rates by selling bonds, it sucked reserves out of the system, which shrunk the monetary base, and shrunk (or at least slowed the growth) of the broader money supply. This would slow the economy and often push it into a recession if the Fed tightened too fast or too long.
A critical change happened in 2008, and it altered the usual relationship between interest rates and the quantity of money in the economy: The Fed gained the ability to pay interest to banks on the reserves it requires them to hold, plus any excess reserves they maintain. In practice, this means the Fed can now influence interest rates without having to change the amount of reserves banks hold.
The Fed can now change interest rates by changing the rate it pays banks for reserves (and through other loan agreements it makes with banks, like repurchase agreements, known as repos). If it wants to raise rates, it can just pay higher interest. Since most banks won’t want to lend at a lower rate than they can safely earn holding reserves for the Fed, this has the effect of raising rates generally in the economy.
At the same time, the Fed has continued traditional open market operations as well as engaged in “quantitative easing” — a fancy name for buying long-term bonds. This has had the effect of significantly increasing the amount of reserves banks hold. But, critically, those excess reserves did not increase the broader money supply as would have happened prior to 2008. The Fed pays generous rates of interest on reserves (above short-term U.S. Treasury rates in some cases), creating incentives for banks to hold funds rather than lend them.
The end result is that the usual predictable relationship between the monetary base and the broader money supply no longer holds. This matters because if you believe monetary fluctuations are a primary driver of business cycles and recessions — as many economists do —then the quantity of money in the economy is now more market-driven than it was prior to 2008. It is being determined by the borrowing and lending activities of banks, mostly independent of the Fed’s short-term actions to manipulate interest rates and reserves.
This is not to say a recession can’t happen. The Fed could lower the interest rate it pays on reserves, which could set off a traditional boom-and-bust cycle. Or the Fed could fail to provide more reserves in instances where credit markets tighten, as has occurred recently in the repo markets.
Perhaps more importantly, recessions can be caused by factors other than monetary forces. Natural disasters are one obvious source of economic downturn that has nothing to do with money. Another danger might be a trade war between the United States and China. Yet another might be technological forces, like big automation breakthroughs that displace large numbers of workers.
Taken together, however, the odds of a recession in 2020 just don’t seem that high. We can be thankful that the Federal Reserve has become less of a source of disturbance than it used to be. Due to some smart reforms, the next recession is less likely to be Fed-driven, and more likely to be come from somewhere altogether unexpected.
James Broughel is a senior research fellow with the Mercatus Center at George Mason University.