Why I Am Not Using the R‑word This Time

This article appeared in the Financial Times on January 2, 2008.

On January 10 2001, the Financial Times wrote that I was “the first prominent economist to use the R- word”. The White House gathered more than a dozen economists to discuss the economy that April and I was still the only one saying the recession had begun.

Unlike in 2001, many economists now seem unusually eager to declare the US precariously near recession. Even the former Federal Reserve chairman, Alan Greenspan (one of the last to notice recession in 2001), recently said there was a 50 per cent chance of a downturn soon.

Why have I not joined this chorus? The answer has little to do with a hypothetical housing‐​led or consumer‐​led recession, neither of which finds much support in historical experience. My doubts about an imminent recession largely stem from some un­resolved academic disputes about the relative importance of oil prices and interest rates. Those seemingly arcane controversies seem worth revisiting, if only because they involved Ben Bernanke, the current Fed chairman.

In 1983, the economist James Hamilton shocked the profession by showing that “all but one of the US recessions since world war two have been preceded, typically with a lag of around three‐​fourths of a year, by a dramatic increase in the price of crude petroleum”.

Professor Hamilton’s thesis was challenged in 1997 by Mr Bernanke, Mark Gertler and Mark Watson. It is difficult to isolate the effect of oil prices on recessions, they argued, because “a number of the most significant tightenings of US monetary policy have followed on the heels of major increases in the price of imported oil”. They found that “an important part of the effect of oil price shocks on the economy results not from the change in oil prices per se, but from the resulting tightening of monetary policy”.

As if to illustrate the point, in 1999 – 2000 the Fed lifted the Fed funds rate from 4.6 per cent to 6.5 per cent while the price of crude oil rose from $12.01 a barrel in February 1999 to $34.40 in November 2000. The economy was once again hit with the double whammy identified by Mr Bernanke, Mr Gertler and Mr Watson.

In an earlier study, in 1990, Mr Bernanke had focused on financial indicators of impending recession, discovering that those measures mainly reflected Fed policy. He found “the spread between the commercial paper rate and the Treasury bill rate appears to be the best predictor”. However, he added, that was “not so much because it is a measure of default risk (which has been the usual presumption), but because it is an indicator of the stance of monetary policy”.

By the late 1990s, other research suggested that an inverted yield curve was a better predictor of recession, including studies by Frederic Mishkin (now a Fed governor) and Charles Plosser (now president of the Philadelphia Fed). In a study with Arturo Estrella, now at the New York Fed, Prof Mishkin found stock prices useful in the short run, but “beyond two quarters, the slope of the yield curve emerges as the clear choice”.

The yield curve, however, is also an indicator of the stance of monetary policy. In a paper with Alan Blinder (who later became vice‐​chairman of the Fed), Mr Bernanke found “the Federal funds rate dominates both&helip;bill and bond rates in forecasting real variables”.

The Fed funds rate was deliberately pushed above the 10‐​year bond yield in 1969, 1973 – 74, 1979 – 81, 1989 and 2000. It was no coincidence that the US economy was always in recession a year later — in 1970, 1974 – 75, 1980 – 82, 1990 and 2001.

Oil prices were rising before each of those recessions, as Prof Hamilton rightly noted. That, in turn, leads us back to that controversy with Mr Bernanke about whether it was rising oil prices per se that caused recessions, or whether focusing too much on energy prices rather than core inflation may have misled the Fed into keeping interest rates too high for too long in, say, 1991 and 2000.

In 2007, by contrast, the Fed stopped chasing higher oil prices with higher interest rates. As a result, the US embarked on a fascinating new experiment in which oil prices and interest rates were moving in different directions for a change.

If the emphasis on oil prices in Prof Hamilton’s 1983 study is correct, the US economy is likely to slip into recession because of higher energy costs alone, regardless of what the Fed does. If Mr Bernanke’s 1997 study is right, timely reductions in the Fed funds rate should avert such a recession.

The bad news is that if oil prices fall sharply this year, as I expect, we may not get a clear answer to that old debate. The good news is that if both oil prices and central bank interest rates are heading down, neither of the academic economists’ most reliable predictors will be signalling recession.