The events leading up to the coming downturn

Further to my thinking from last post, I began to consider the two other recession indicators I have discovered - obviously they will both turn negative in time for the next downturn. This means there is a possibility that we can predict what may occur.

In short we have two potential outcomes leading up to the downturn: an inflationary one or a deflationary one.

Net Monetary Base vs Inflation (spread)

This measures the growth of the net monetary base (M0 minus excess reserves) over inflation. My original study is here. If we assume that a recession is due, what will happen to this indicator as it approaches? For the spread to turn negative, inflation must exceed the growth of the net monetary base. This can happen one of three ways: An increase in inflation; a decrease in the Net Monetary Base; a combination of the two.

An inflationary outcome would result in inflation outstripping the new monetary base. This would mean that, in the time leading up to the recession, inflation would increase. If the Fed does not instigate any Quantitative Easing, the chances are that this increase in inflation won't necessarily be big. Although a Latin America style inflation increase is possible, it's probably likely for inflation to get close to 10% and not much more before the recession hits. The only reason I use for this is that, historically, the US hasn't experienced a hyper-inflationary hit.

We need to also understand that the Fed has probably pushed the inflation limit to around 6%. I remember Krugman talking about this and the Fed's reluctance to increase the Federal Funds rate (currently 0.09%) in the face of growing inflation (now 3.4% - the last time inflation increased to around this level in October 2007, the Federal Funds rate was 4.76%) speaks for itself. So we're probably looking at inflation increasing to beyond 6% and up to around 8% before the Fed begins to push rates up again. By that stage inflation would have increased beyond the growth of the Net Monetary Base.

An increase in the price or oil and/or a decrease in the value of the US Dollar (the USDX) is likely to accompany this inflationary growth.

For a deflationary outcome, this would mean that the Net Monetary Base would be shrinking faster than the inflation rate - which would remain benign or turn into deflation. Only once in postwar history has the Net Monetary Base declined: in December 2000 and January 2001, a decline which presaged a recession later in the year.

The deflationary outcome, like the inflationary one, won't have to be sudden or substantial to presage the recession. If inflation sits at 1% and the Net Monetary Base grows as 0.5% - both near zero but slightly inflationary - the result will still be a negative spread and an upcoming recession.

A decrease in the price of oil and an increase in the value of the US Dollar (the USDX) is likely to accompany this deflationary outcome.

The May 2011 result for this indicator was 540, still in positive territory. As the recession approaches this number will drop quite substantially. Moreover, considering the time it will take for this result to drop, a 2011 Q3 recession start date (next quarter) is highly unlikely.

Federal Funds Rate vs 10 Year Bond Rate (spread)

This measure the difference between the 10 year bond rate (GS10) and the Federal Funds Rate (FEDFUNDS). When the 10 Year bond rate drops below the Federal Funds Rate, the data indicates that a recession will follow.

The 10 Year Bond rate is, according to my stock ticker, 3.11%. The Federal Funds Rate is currently 0.09%. In order for this spread to turn negative, the Federal Funds Rate must increase, or the 10 Year Bond Rate must decrease, or a combination of the two must occur.

The only way the Federal Funds Rate will be increased is when the Fed decides that the problem of inflation is greater than the problem of high unemployment and low economic growth. As I stated above this thinking seems to hover around the 6% inflation level, so chances are that the Fed will begin to raise the Federal Funds rate once inflation begins to increase beyond 6%. As these rates go up in response to more inflation, it will inevitably exceed the 10 Year Bond Rate, thus presaging the downturn. This is the inflationary outcome.

The deflationary outcome would mean that the Federal Funds Rate remain low while the 10 Year Bond Rate crashes down to similar levels. This, in turn, would mean that the Bond Rate would be 0.09% or below. This, of course, would indicate massive financial distress that would be accompanied by a sharemarket crash of epic proportions and a credit crunch that would make 2008 look like a picnic. A soaring US Dollar is likely to accompany such a crunch (as it did in 2008).

So what will happen?

The most likely scenario in my mind is one in which inflation increases beyond 6%, forcing the Fed to increase the Federal Funds Rate. This growth in inflation will exceed any increase in the Net Monetary Base. The increase in the Federal Funds Rate will also allow the spread between it and the 10 Year Bond Rate to narrow and eventually turn negative.

The reason why this is the most likely scenario is that inflation is already increasing, and the Fed has chosen a deliberately inflationary policy (Quantitative Easing). Peak Oil ensures that oil supplies will be harder to maintain, thus forcing an increase in oil prices and thus inflation.

So when will this happen?

As I have pointed out in my last prognosis, the next downturn will begin any time between 2011 Q4 and 2012 Q4. In the 6-18 months prior to this, we will see inflation increasing beyond 6%.

It's important to keep an eye on the recession indicators over the coming months. Watch as the Net Monetary Base / Inflation spread begins to drop towards zero. As inflation increases keep an eye on Fed announcements on monetary tightening, with the knowledge that an increase in the Federal Funds Rate will inevitably lead to a negative spread between the funds rate and the 10 Year Bond Rate.

Can the downturn be avoided?

No. I'm fairly certain that it will happen within the timeframe that I predict. The only thing that would save us is a return to positive real interest rates in June, a result that would imply an increase in bond rates and/or deflation.

What would OSO do if he were Ben Bernanke, armed with this knowledge?

Raise interest rates / tighten monetary policy. Get the recession over and done with. Set a tighter inflation target (preferably "zeroflation"), rather than a looser one.

What will we learn from this experience?

The 2008 crisis caused a rethink in inflation expectations - specifically whether current inflation targets weren't working. I agreed with this rethink but suggested that future policy be aimed at what Krugman calls "Hard Money". My argument was and still is that prices need to remain constant, neither inflating nor deflating over the long run, and that the best way to measure success at this level is to have the GDP deflator at zero over the long term. Unfortunately current thinking is that inflation targets need to be looser rather than stricter (eg Krugman, Stiglitz). I believe that these loose policies have created the conditions for negative real interest rates which will now doom the US economy to another downturn. Had "Hard Money" policy been enacted (by which inflation was controlled), there is no doubt that the current recovery would be slower but at least it would be sustainable. As it is, the loose money policy will simply create another bust and make things even worse.

I've also believed that national debt needs to be paid off rather than inflated away or defaulted. Using the policies we already have at hand I have suggested that the best way to turn around government finances is to raise taxes on the rich rather than cut spending. Taxing an overinvested share market through a Tobin Tax or a market capitalisation tax would serve to both punish financial bubble formation and create revenue to pay back debt. As for new policy, I would suggest someone seriously implement part of my zero tax economic system and simply pay off debt through money printing (what is now known as Quantitative Easing) while increasing the reserve ratio to prevent any resulting inflation. And as for reducing unemployment... set up a universal employment subsidy that makes it cheaper for firms to employ people while simultaneously raising wages - all at the expense of higher taxes (or more QE).


Real Interest Rates are predicting an upcoming recession

Best to read this first. Then read this.

Also remember that while recessions can occur without negative real interest rates, whenever negative real interest rates do occur, they are always followed by an eventual recession.

I played around with my spreadsheet even further and averaged out the real interest rate (10 year bond rate minus inflation) over a three month period to see what that would achieve. The results seem far more promising than merely measuring monthly results:

July 1954 - May 1961

Fairly clear here in the fifties. Our first result is a negative reading measured in March 1957 and lasts for three months. A recession follows in October of the same year. A further deterioration in the real interest rate occurs during the recession and it is possible that this may have prolonged the recession already in swing.

May 1961 - May 1971

Nothing here in the sixties to help us. The Beatles were probably responsible.

May 1971 - May 1981

Two huge results for the disco decade. Our second negative result in October 1973 leads to a recession in January 1974. There is a long period of recession and negative interest rates that lasts until October 1975. Rates remain positive for a while but return to negative again in November 1978, which is our third result. A long period of negative interest rates follows before a recession hits in April 1980. As with the previous recession, as soon as the rates return to positive the recession is over.

May 1981 - May 1991

Nothing here in the eighties to help us.

May 1991 - May 2001

The nineties doesn't help us either.

May 2001 - May 2011

The 2000s provides us with the fourth and last result. Rates turned negative in January 2008 and a recession follows in April.

2005 does provide us with a near negative result: 0.06% in October that is most likely associated with Hurricane Katrina (the monthly inflation increase in September 2005 was the 5th highest on record). In fact it is this 2005 result which forced me to reassess my study two weeks ago on real interest rates based upon the 10 year bond rate (which is not averaged out over three months) and caused me to predict a recession in 2012 Q4.

From the four results, I have deduced the following information:
  • Once the results turn negative, a recession occurs, on average, 8½ months later.
  • The median is 6 months.
  • Results vary between 4 months and 18 months.
  • The highest unemployment rate during the recession is, on average, 1.8 times the unemployment rate of the month when real interest rates turn negative.
  • The lowest increase is 1.32 times; the highest increase is 2.03 times

As you can see from the final graph, above, real interest rates have plummeted in recent times. Here is a graph encompassing the past three years:

The final result - May 2011 - has a reading of 0.26%. This is very close to a negative reading and, therefore, another recession.

In order for a recession to be averted, ten year bond rates must increase or annual inflation must drop. Playing around on my spreadsheet shows me that if the Ten Year Bond rate is 3 basis points lower than the annual inflation rate (eg Bond rate of 3.17%; Inflation rate of 3.2%), then US real interest rates (10 year bond rate minus annual inflation, averaged over three months) would sit at 0.01%, still a positive result. Any result of 4 basis points lower or more would end up giving an negative result.

What are the chances of a negative result for June? Fairly high. 10 Year Bond Rates are, according to my stock ticker, at 3.04%. If bond rates stay at May's result (3.17%), then the inflation index would have to read 223.74 for a positive June result. This would imply a 0.5% drop in prices from the previous month.

Realistically, therefore, we are looking at a negative June result. Which would mean the following:

  • A recession starting between 2011 Q4 and 2012 Q4, with 2012 Q1 the most likely.
  • If unemployment remains at 9.1% in June, then the new unemployment peak during the upcoming recession will be between 12.0% and 18.5%, with 16.7% being the most likely result.

Of course I need to point out that all the information I have extrapolated is based upon four results of negative real interest rates occurring between 1957 and 2008. It may be that this time around things might be different: the recession may take a much longer time to occur; the rise in unemployment may be lower than anything beforehand; the length of the recession may only be short. Nevertheless I do believe that the data is on my side and that, barring any miraculous June result that would turn conditions around, another recession is highly likely to occur, with an unemployment peak higher than any other postwar period.

Sources and methodology

For negative real interest rates:

St Louis Fed: 10 Year Bond Rate GS10
St Louis Fed: Inflation Index CPIAUCSL

For Recession:

St Louis Fed: Real GDP GDPC1
St Louis Fed: Population POP

I define a recession as an annual decline in real GDP per capita.

Here's a screenshot of part of my spreadsheet to help make sense of it all (my methodology)


US Recession Indicators - June 2011

According to data from negative Real Interest Rates, another US recession is likely to occur between 2012-Q1 to 2014-Q1, with 2012-Q4 being the most likely. See below.


Net Monetary Base vs Inflation (spread)

The growth of the Net Monetary base (M0 minus excess reserves) over inflation has been above the historical average since September 2010 and has increased even further with an April reading of 540. This is an increase from last month's reading of 536.

Inflation readings in May continue to grow. The index reading of 224.804 implies annual inflation of 3.4%. Prices since December (220.186) have increased by 2.1%, which implies an annualised inflation rate of 5.0%, still uncomfortably high. As 2011 continues the momentum of these high monthly figures will translate into higher annual inflation.

Since the introduction of QE2 in November 2010, the net monetary base has increased faster than inflation.
Note: A negative result implies that inflation is growing faster than the money supply, an event which indicates that a recession will occur within 1 to 36 months (with an average of 12 months).

Data Series:
St Louis Fed


Federal Funds Rate vs 10 Year Bond Rate (spread)

The 10 Year Bond Rate has increased over the past few months while the Federal Funds rate remains at near zero. The April spread comes in at 308 basis points, well above the historical average.

Note: A negative result implies a highly restrictive monetary environment, an event which indicates that a recession will occur within 4 to 39 months (with an average of 22 months).
Note: If both the first and second graphs are negative at the same time it indicates that a recession will occur within 1 to 21 months (with an average of 11 months).

Data Series:
St Louis Fed



Real Interest Rates

As a result of recent discoveries in this area of Real Interest Rates, I have chosen instead to report the monthly results of 10 Year Bonds Rates minus inflation, rather than the previous method of the Federal Funds Rate minus inflation.

As this recent discovery noted, real interest rates in the US dropped to -0.27% in May 2011, which means that a recession indicator has been triggered. Since recessions have occurred between 5-32 months after negative readings, we can expect another recession to begin between 2012-Q1 to 2014-Q1, with 2012-Q4 being the most likely.

Note: Real Interest Rates based upon 10 year Bonds can indicate how the value of money is determined in comparison with the market's safest investment. A negative result implies that inflation is eroding the savings of those who have invested in 10 Year Bonds, and indicates that a recession may occur between 5-32 months, with an average of 16.5 months and a median of 14.5 months.

Data Series:
St Louis Fed





A Recession indicator has been triggered

One measure of real interest rates went into negative territory after the release of last week's inflation figures. The history of this measurement clearly shows that a recession will follow. If my estimations are right, a US recession will occur in probably 16½ months (2012 Q4), with anything from 5 to 32 months possible.

This measurement of real interest rates is not the one I have been studying in my monthly recession watches, but another one which I have mentioned before on this blog.

The "Real Interest Rate" is usually defined as the nominal interest rate minus inflation. In the case of the US, this is usually measured as the Federal Funds Rate minus the annual inflation rate. Yet this measurement can be problematic since the Federal Funds Rate is controlled not by the market, but by the Federal Reserve Bank. So instead of using the Federal Funds Rate, I have often used the 10 year bond rate as the interest rate part of the equation. So in this case, it would be the 10 year bond rate minus annual inflation.

I initially dismissed this measurement of real interest rates because a quick glance at its history showed that recessions have occurred without this real interest rate turning negative. But after last week's inflation report, and the subsequent negative result for this real interest rate on my spreadsheet, I began to study it a bit more. Here is the data since 1954:

It's clear that there are a lot of recessions since 1954 that didn't involve this negative real interest rate. Recessions in 1954, 1956, 1970, 1982, 1991 and 2001 all occurred when real interest rates were positive. Yet this is not the whole story. What I discovered from this analysis is that while recessions can occur without negative real interest rates, whenever negative real interest rates do occur, they are always followed by an eventual recession. This occurred in 1957, 1974, 1980 and 2008.

The longest period between a negative real interest rate result and an eventual recession is 32 months, and that occurred in 2005, with the 2008 recession following it. The 2005 result may seem to be an exception to this rule, but when compared to similar recession markers from that period, the 2005 result pretty much correlates with the inflationary surge caused by Hurricane Katrina.

So what about the present? Last week US inflation for May 2011 came in at 3.4438% while Ten Year Bond Rates for that month were 3.17%, which meant that real interest rates dropped to -0.2738%. You can see this on the last graph above, with the line dropping below zero. If real interest rates rebound into positive territory for June, thus giving it a single negative month, it will be similar to the 2005 result (September 2005 came in at -0.54%, but with over 24 months of positive results after it). But if the June result continues to be negative, and if this continues into July, then the chances are that a recession will be sooner rather than later.

Of course despite the fact that data goes back to 1954, there is just not enough historical correlation to make a 2012 Q4 recession (or thereabouts) an absolute certainty.

As a tl;dr, remember this:

Whenever Negative Real Interest Rates (10 year bond rate minus annual inflation) do occur, they are always followed by an eventual recession.


Credit Market Debt as percentage of GDP


Credit Market Debt: TCMDO

GDP: St Louis Fed.

All figures are quarterly.


Cost of oil consumption to US economy


Oil Consumption: EIA

Oil Price: St Louis Fed.

GDP: St Louis Fed.

Recession defined as decline in annual real GDP per capita.

All figures are quarterly.