Here’s That Rainy Day

Like the visitation of a medieval plague, Recession seems to have returned to our shores. These events are rare. So what exactly is a recession? I quite like Christopher Dow’s (Major Recessions, Britain the World, 1920-1995, OUP, 1998) definition of a fall in the level of GDP in one year compared to the previous year. According to Dow we only had five major recessions in the post-WW1 20th century (three after WWII) and it looks as though we are about have our first of the 21st century. In a book which will now be re-read, Dow finds that in these recessions, which typically have duration of around 1-3years, the level of output typically falls by up to 10% below the level it would have arrived at if trend growth was maintained. (He attributes around half this fall to a reduction in productivity.) During these episodes unemployment typically rises by up to 3-4% points.

A key additional finding is that recessions seem to have been unpredictable in real time, reflect changes in demand as much as any supply reductions and occur nearly simultaneously in major economies. Clearly the simultaneous occurrence of negative growth across economies might well be a candidate explanation for the severity, as trade multipliers will be running at full pelt. I do not know whether this recession will be a major one or not but the extent of the fall today in Sterling (closed on 22nd October 88.3 compared to previous day at 90.4 with Sterling falling over 6c against the US$ alone) and in the equity index (FTSE-100 and FTSE All-Share both fell by over 4%) suggests that the financial markets expect both a strong negative domestic interest rate response, which drags down sterling, and a large fall in corporate profitability, which drags down the equity index (recall that equity prices should be present value of expected corporate profits, which are in return a function of output).

In a speech on Tuesday, the Governor of the Bank of England gave two reasons for the recession. The credit market shock, which has deprived household and firms of liquidity against their collateral in some degree and so reduced demand, and a global price shock to fuel and commodities that has reduced household disposable income, rather like a large unanticipated tax rise levied by a foreign government. I suspect the financial shock has another consequence. The impecunity of the UK household balance sheet has been exposed - as perceptions of net wealth have been eroded with sustained falls in asset prices. And this means that the UK private sector balance sheet, currently well in deficit to the tune of around 5% of GDP, is certainly even more in need of a sustained bout of savings, which will surely reduce demand further.

Each of these arguments concern demand and so can, to some extent, be offset by appropriate interest rate policy. The Table above dates the trough and peak in the business cycles around the time of Dow’s major recessions. I also note level of policy rates at around the same time with their nearest peaks and troughs.

The peaks in interest rates occurred sometime after the business cycle peak but there is no clear pattern in the interest rate troughs (as in the most recent recession, policy rates were constrained by ERM membership). When inflation was more of a problem, in the earlier recessions, interest rates did not move especially far in proportional terms – falling by around 25-30% of their peak value in both cases. But when inflation was reasonably under control, as in the most recent recession, interest rates fell by a much larger fraction, by around 65%. If we mechanically apply these boundaries to the current scenario, we arrive at a corridor for base rate at 4.00% to 2.00% as the floor this time round. Clearly the current consensus is for inflation to reduce radically as commodity prices fall in response to lower world demand and the increasingly large negative UK output gap drives down pricing power of firms.

And so we might conclude for the moment that the markets have priced more of the latter scenario in than the former and hence the large exchange rate and equity price responses we have observed. But as ever we shall have to wait and see what that rainy day actually brings.