Why economists' predictions of a US recession were so wrong

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Over the past two years, most economists have predicted a recession in the United States. In fact, this is the most widely expected recession that did not occur. Like Godot, this was a no-show.

This became increasingly evident at the start of this year. However, even though most backed away from their gloomy recession forecasts, many predicted that the Federal Reserve would have to cut interest rates several times to avoid a recession if inflation continued to moderate. This prediction also seems wrong, and more and more economists are now talking about the prospects of higher, longer-term interest rates.

It was logical to expect a recession over the past two years. After all, the Fed raised the federal funds rate by 5.25 percentage points between March 2022 and July 2023. It surely seemed that such a significant tightening of monetary policy would cause a breakdown in the financial system, triggering a tightening credit that causes a recession. When that happened, the Fed would be forced to quickly lower interest rates. This has been the modus operandi of most monetary policy cycles since the 1960s.

Many reliable indicators announced the arrival of a recession. The yield curve between 2- and 10-year U.S. Treasuries inverted during the summer of 2022, with short-term rates rising above long-term rates. This was what it had done just before previous recessions. The index of leading economic indicators reached a record high in December 2021 and declined since then until April, signaling a recession. The growth rate of real M2, a measure of money supply on an annual basis, turned negative in May 2022 and remains negative until March.

But that's why I think the economists were so wrong and why these indicators turned out to be misleading:

Past recessions were mainly caused by credit crunches, soaring oil prices or the bursting of speculative bubbles. The inverted yield curve accurately anticipated a financial crisis, this time as in the past. There was a banking crisis in March 2023, but it did not last very long and it did not cause a credit crisis because the Fed responded quickly by setting up an emergency liquidity facility for the banking sector. The price of oil soared after Russia's invasion of Ukraine in February 2022, but abundant global supplies and weak global economic growth quickly caused it to fall. The price of oil rose again in March as the war between Israel and Hamas showed signs of morphing into a regional conflict, but has since declined.

The economy also proved more resilient than economists expected, mainly because consumer spending continued to grow. Many households benefited from higher rates on their bank deposits and money market funds. Many also refinanced their mortgages at historically low rates in 2020 and 2021.

More importantly, the baby boom generation has begun to retire with a record net worth of $76 trillion. They spend on restaurants, cruises, travel and health care. All of these service industries have increased their workforces, thereby increasing real incomes and fueling more spending. The goods sector of the economy has been in a growth recession since around March 2021, following the buying frenzy that occurred when the lockdown was lifted. Nonetheless, spending on goods remained at a record level on an inflation-adjusted basis.

Elsewhere, restrictive monetary policy was offset by very stimulative fiscal policy. Federal deficits have been widened by extensive federal spending on infrastructure and federal government incentives for relocation. The federal government's net interest spending soared, pushing personal interest income to a record high.

Corporate profits and cash flows have also held up very well. Capital spending was not reduced by higher rates as many companies raised cash and refinanced while borrowing costs were very low in 2020 and 2021. Capital spending was also driven by relocation as well as numerous expenditures on technological hardware, software and research and development. . As a result, productivity growth rebounded last year and is expected to remain strong.

And what about the Index of Leading Economic Indicators? It has not worked as well because it is heavily weighted toward the goods economy, which has been relatively weak, and does not give enough weight to the services sector, which has been strong.

Economists must remember that history does not always repeat itself and does not always rhyme. They should rely less on leading indicators and other simplistic models and more on common sense.

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