LONDON (Reuters) – “The longer the war goes on, the higher the chance of an economic recession,” the chief executive of commodity trading company Vitol said on Tuesday at a conference of business leaders organized by the Financial Times.
Recession risks were already high before the Russian invasion of Ukraine, and the subsequent rise in commodity prices and disruption of supply chains has exacerbated adverse economic trends.
Recessions have proven difficult to predict or identify when they first begin, even for the most experienced researchers of the business cycle.
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Mostly, recessions are caused by a complex interaction between production, employment, prices, costs, productivity, interest rates, and credit, among other variables, rather than a single external shock like rising oil prices.
But a sudden rise in the price of oil, or some other shock, could act as a tipping point if the business cycle really becomes vulnerable to a downturn, as was most likely the case at the start of 2022.
Crunch cost of living
Prior to the Russian invasion, major economic and financial indicators painted a mixed picture of the state of the American business cycle.
(Graphic Book: https://tmsnrt.rs/37U1EQs)
Production and employment indicators were strong, indicating that a recession is not likely for at least another six to 12 months, but price and income indicators were more pessimistic.
US manufacturing production rose nearly 1.2% during the three months from November to February, according to the Federal Reserve, indicating that the economy has strong positive momentum.
Manufacturers report widespread improvement in business conditions, with the Institute for Supply Management’s (ISM) composite index standing at 58.6 in February.
The ISM index was well above the 50-point threshold indicating expansion rather than contraction, although it has already begun to retreat from its peak in the summer of 2021.
The number of non-farm payrolls increased by more than 1.7 million between November and February as businesses reopened and rehired after the coronavirus recession and shutdowns.
But core consumer prices for items other than food and energy have been rising at an annual rate of more than 6%, consistent with the onset of recessions in previous business cycles.
The Treasury yield curve has been significantly flat and the spread between 2 and 10 years has narrowed to consistent levels in the past with the onset of a recession or at least a mid-cycle slowdown.
Real personal income least transfers (PILT) fell 0.3% between October and January, according to data from the US Bureau of Economic Analysis, as wages failed to keep pace with rising prices.
PILT is one of a set of indicators that the National Bureau of Economic Research’s Business Cycle Dating Committee uses to identify peaks and troughs in the business cycle.
The three-month decline in PILT has put the index at just the 14th percentile for all months since 1990, which helps explain why consumer confidence has waned even as job growth continues.
PILT growth has fallen to rates that heralded the start of recessions in 1990, 2001, 2007 and 2020 and a mid-cycle slowdown in 1995, 2005, 2012 and 2015.
The contrast between the strong surveys of industrial production and business on the one hand and the weakness revealed by PILT on the other confirms that the main problem of the economy is the cost of living crisis.
The Russian invasion and sanctions in response exacerbated this problem by driving up oil and gas prices and disrupting other manufacturing and food supply chains.
tipping point problem
It is difficult to predict a recession in real time because by definition the start of a recession is also the peak of a previous expansion.
Business cycle slowdowns almost always start when business and employment conditions have been relatively good until recently.
The recent recovery encourages forecasters to be over-optimistic that positive conditions will persist and underestimate the likelihood that the economy will be at a tipping point.
The economist Victor Zarnowitz wrote in his historical study of business cycles: “The biggest errors in forecasts… lie near the business cycle and the turning points of the growth cycle, particularly the peak.”
“Many forecasts are overly influenced by recent events or developments; they depend on the continuation of local trends and are not sufficiently cyclical,” he said. (“Business Cycles: Theory, History, Indicators, and Forecasting”, 1992).
Forecasters also have professional reputation reasons to maintain an optimistic outlook and anticipate a soft landing for the economy.
“The forecaster is understandably careful to avoid falsely or prematurely predicting an economic downturn before others, which explains why the warnings of some indicators are not heeded,” Zarnowitz wrote.
As a result, professional forecasters routinely fail to identify tipping points until after they have occurred, even when the data begins to fall flat.
The critical question is whether the invasion and sanctions will exacerbate negative trends in the economy enough to push it into a major slowdown or even a full-blown recession.
The economic shock caused by the Russian invasion is much smaller than the one caused by the spread of the coronavirus epidemic around the world in the first quarter of 2020.
But it is at least the size of the shocks caused by Iraq’s invasion of Kuwait in 1990, the Iranian revolution in 1979, and the Arab oil export ban in 1973, which was followed by a recession.
The current shock is also spreading through multiple channels simultaneously, including the energy system, the food system, manufacturing supply chains, the international shipping network, and the global payments system.
Complicating the picture, the US Federal Reserve and other major central banks are trying to bring down inflation, limiting their room to cut interest rates or ease credit conditions to offset any negative impact on business.
Recessions usually occur, as now, when there is a discrepancy between policy goals, forcing central banks and governments to make an uncomfortable choice, prioritizing other goals at the expense of a temporary slowdown in production and employment growth.
The magnitude and complexity of the current shock makes the business cycle impact particularly difficult to predict but in the context of an already acute inflation problem it is likely to be significant and negative.
Even if the United States manages to avoid a recession, Europe is more integrated with the Russian economy, so the potential for a recession is much greater.
The more conflict and sanctions escalate, and the longer they last, the greater the turmoil in the economy and the greater the potential for a recession.
– Western economies on the brink of recession as sanctions against Russia escalate (Reuters, March 8) Read more
Global recession risks rise after Russia invades Ukraine (Reuters, March 4th) READ MORE
– The global economy is facing the biggest headwind from inflation (Reuters, October 14).
John Kemp is a market analyst at Reuters. The opinions expressed are his own.
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Editing by David Clark
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