In most advanced economies business cycles can be characterised by a succession of long expansion phases interrupted by short recessions. While other variables matter (such as the depth and length of recessions), in the case of the U.S. and to some extent in the case of European countries, the parameter that has changed the most across cycles is the length of the expansion phase, thus it is natural to look upon the length of the expansions as a key feature of the cycle.
In the case of the U.S. post WW II (using the NBER business cycle dates), expansions periods have lasted between 12 months ( the cycle which concluded in 1981) to 120 months (that ending in 2001). Today's expansion period has already exceeded 77 months, longer than the previous growth spurt of 2001-2007.
While counting months is not an accurate way to forecast the timing of economic activity, it is at least a reminder that there is another recession waiting for us in the not-so-distant future. And the key question is, are we ready for it? In particular, will monetary policy be back to normal and able to react?
Are we ready for a downturn?
Interest rates have not yet moved away from zero in Europe, the U.S. or Japan. This is, of course, very unusual given the length of the expansion. Another way to see just how unusual is the relationship between monetary policy and interest rates, is to plot the difference between long-term rates and the central bank rate.
In the case of the U.S. we can see that this difference (the term premium, or to put it simply, the compensation investors require for accepting the risk that short-term Treasury yields may not move as expected) has stayed very high since the 2008-09 recession. Unlike previous expansions where after two to four years the term premium started declining (mostly through increases in the short-term rate), in this case the number remains unusually high.
There is a positive reading of the chart that suggests that we are far from the next recession. And if we assume that the term premium has to get very close to zero before a recession happens, then yes, it will take a while before we see the next one. But that reading ignores the fact that today, short-term rates are abnormal, they are stuck at the zero lower bound. But recessions do not always happen because the term premium decreases. They can happen for other reasons and it is coincidence that the term premium moves with the cycle. It is interesting to note that the current expansion is not like the others because of the constraints on short-term rates, so it might possibly be that the difference with long-term rates will this time be a really bad indicator of how close we are to a recession.
A matter of urgency
A second reading of the chart reminds us of the risk we face if the next recession is in the not too distant future and monetary policy has not had the time to return to normal. Entering the next recession in Europe or the U.S. with interest rates that are too close to zero does not bode well.
In addition to the need for economic conditions and monetary policy to return to normal, there is an additional sense of urgency should a domestic or global event cause a recession in the near future.
In a world with very low interest rates, central banks and governments need to look forward and make sure that planning for the next recession is part of their strategy to ensure the fastest possible recovery from the previous one.
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