If There is an Economic Downturn, When Will It Begin?

Among the recessions listed in the table above is the brief, but deep, downturn that began in February 2020.  It was caused by the policy response to the COVID-19 pandemic, and we will never know if a normal cyclical downturn would have happened had the pandemic not occurred.  Excluding the 2015-2018 tightening cycle from the analysis, Fed tightening cycles were followed by downturns only in three of the five cases.  This suggests that the probability of a recession in the relatively near future might be as low as 60%.

However, there are several reasons to think that the risk of an economic downturn might be much higher. For starters, the Fed hiked rates by 500 bps in the past 14 months.  This is far greater than in any previous tightening cycle since 1981.  The 1981 tightening cycle, which was part of a broader period of tightening that began in 1979, resulted in the deepest recession since the Great Depression of the 1930s.  

A second reason why the probability of a recession in the next two years might exceed 60% is the level of debt and leverage in the U.S. economy.  Previous tightening cycles happened during periods of much lower levels of leverage.  For example, the total debt-to-GDP ratio was around 130-135% at the time of the 1979 and 1981 tightening cycles.  By the time of the 1984 tightening cycle, the ratio had risen to 150%.  When the 1989 tightening cycle ended, it was 180%.  By the May 2000 peak in Fed funds, it was 185%, and by the time the Fed stopped hiking rates in 2006, debt had risen to 217% of GDP.  As of Q3 2022, the most recent quarter for which we have data, the total U.S. debt-to-GDP ratio was 257.5%.  So not only does the size of the Fed’s current tightening cycle dwarf anything that it’s done in the past 40 years, the combination of public and private sector debt is also far larger than it was during past tightening cycles.