scorecardresearchIs a recession coming? Here's what a look at history indicates
One key trend, the brokerage observed, among the 5 recession periods is that the real interest rates turned positive ahead of the recession, which has not yet happened this time.

Is a recession coming? Here's what a look at history indicates

Updated: 14 Mar 2023, 03:13 PM IST

Centrum Broking, in its recent report, has analysed each of the recession periods of the past, to understand if there is a visible pattern that may precede a recession.

Starting March 2022, the Fed has hiked interest rate by the fastest pace in a single year since the 1980s, taking its borrowing rates to the level seen in 2007. In a recent report, Centrum Broking noted that historically, such rapid rate hikes almost every time led to a recession. However, it is important to note that while each recession is unique, all cases seem to share some patterns.

In the last 50 years, the US has seen 4 recessions, but no recession has ever started without the real interest rates – interest rates minus the inflation – being positive, informed the report.

It is important to note that the real interest rate represents the true cost of borrowing after adjusting for the effects of inflation. Interestingly, Centrum pointed out that, this time even though Fed has increased rate by 450 bps already in quick succession, the real rate is still negative thereby having a limited impact on the growth and labour market.

Given that the inflation is still above 6 percent, the brokerage believes that in the coming months, US Fed rate is headed towards 6 percent for the Fed to feel confident to pause.

The brokerage, in its recent report, has analysed each of the recession periods, trying to understand their conditions to arrive at a possible trend that may precede a recession. One key trend, the brokerage observed, among the 5 recession periods is that the real interest rates turned positive ahead of the recession, which has not yet happened this time.

Let's take a look:

1973’s recession: The first period when inflation began to skyrocket was at the beginning of March‐1973. During this period, the Federal Reserve raised interest rate from 5.5 percent to 13 percent in order to combat double-digit inflation, informed Centrum. The early 1970s were marked by economic uncertainty, with high unemployment and slow economic growth. All of these factors pushed the real interest rate to edge higher, which made borrowing more expensive and savings more attractive, noted the brokerage. This led to a period of positive real interest rate which averaged around 2.5 percent and thereby dragged the economy into a recessionary period. The severe recession lasted from 1973‐1975, the brokerage revealed.

1980s' recession: Again, in the early 1980s, the economic downturn was triggered by tight monetary policies in an effort to tame inflation. Since the Great Depression, the 1981–1982 recession was the worst economic slump to hit the United States, informed Centrum. The brokerage highlighted that in the third quarter of 1981, the economy formally entered a recession as a result of rising interest rate placing pressure on the economy's borrowing-dependent sectors, such as manufacturing and construction. The unemployment rate also increased from 7.4 percent at the beginning of the crisis to almost 10.4 percent a year later.

As a result of the new focus and the restrictive targets set for the money supply, the federal funds rate reached a record high of 20 percent in late 1980 and inflation peaked at 14.8 percent in March of the same year. In addition to it, the real interest rate (inflation-adjusted) in the US economy reached 10.4 percent in the early 1980s and the interest rate on 10‐year Treasury, adjusted for inflation, averaged over 2.5 percent, between 1980 and 1982, the brokerage noted. This led to a steep recession during this period.

Early 2000's recession: From 4.75 percent at the beginning of 1999 to 6.5 percent by July 2000, Fed raised the rate to its highest level at the time. This was the third time in US history when positive real interest rate was associated with a recession. The recession may have ended sooner due to the Sept‐11 attacks and the ensuing economic disruptions since they pushed the Fed to maintain lower rate, stated Centrum. However, yield curves were inverted and real interest rate turned positive before the recession.

During this period, the early 2000's recession had a significant impact on the US economy, with unemployment rising and GDP growth slowing. The unemployment rate rose from 4.2 percent in January 2001 to 5.7 percent in November 2001, and the GDP growth rate fell from 1.1 percent in the second quarter of 2001 to ‐1.3 percent in the third quarter of the same year, mentioned the brokerage. The Federal Reserve responded to the recession by lowering interest rate, which helped to stimulate economic growth and eventually led to a recovery. The economy began to expand again in the fourth quarter of 2001, and the recession officially ended in November of that year, stated the brokerage.

Housing market crash (2007‐2008): This was the fourth period of recession in the US economy. As per the brokerage, after the early 2000's dot‐com recession, the US Fed reduced the rate to 1 percent in the middle of 2003 and because of the negative interest rate, the GDP increased from 1.7 percent in 2001 to 3.9 percent in 2004. However, by 2005, there were already rumours of a housing bubble in the United States.

During this period the US central bank then managed to hike interest rate 17 times between 2004 and 2006 — all of those increases in gradual, quarter‐point moves — to a high of 5.25 percent in order to ward off inflation, informed Centrum. Hence, the real interest rate moved from negative to positive and the US economy once again entered into a recessionary period, observed Centrum. Moreover, the spread of (10 yr ‐2yr) also indicated an inverted shape during 2006 which brought slower growth in the economy a year later, noted the brokerage.

Present scenario (April 2022‐ now): In early 2020, the US Fed lowered interest rate as global economic activity slowed in the wake of the coronavirus pandemic. The lowest Fed funds rate was in March 2020, after the 2008 crisis, as a result of the global health crisis, however, to curb the high inflation that came after, the Fed began raising interest rate in March 2022. Since then, the Fed has raised the Fed fund rate from 0.25 percent in March‐22 to 4.75 percent till Feb‐23, in order to combat elevated inflation. At the current juncture, headline CPI is at 6.4 percent which still indicates a negative real interest rate.

According to Centrum, as seen in the historic trend, every recession was preceded by aggressive Fed rate hikes along with a positive real interest rate.

"While a recession doesn't automatically follow a tightening; every recession is preceded by real interest rates turning positive, and looking at history, a positive real rate of over 2 percent should be high enough to cause concern. Moreover, when the economy enters into a zone of high positive real interest rates, it causes growth to shrink sharply," explained Centrum. 

In the current scenario assuming the inflation rate at above 5.5 percent average (as per Fed projections) in 2023, Fed rate needs to be north of this to create positive real rate to curtail growth and bring inflation down, thus, setting the stage for Fed pivot and rate cuts to stimulate growth again, added the brokerage.

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First Published: 14 Mar 2023, 03:13 PM IST