Monetary Policy Controls The Business Cycle

At a networking event during the week in France, spoilt by the magnificent mountain views that surrounded lake Annecy, I stood among my colleagues drenched in the evening sun, and quietly wondered to myself was I the only miserable eejit thinking about a recession?

While many of the film studios and streamers in my industry made huge layoffs in recent months, it struck me that almost no one else at the event was overly concerned. What was I missing? When I was stupid enough to bring up interest rates, PE ratios or bond yields, I was rightly met with blank stares. “Fancy yourself as a bit of an economist, do you mate?”. At least it broke the awkward silence.

Many of the studios at the event were there to recruit staff for upcoming projects and meet new clients. Their businesses are still booming and earnings projections for the years ahead are strong. They didn’t need someone like me pissing on their parade using fancy jargon. “Go write a song about it, Barry!” one person joked. “I will” I said. “It's called ‘Don’t Give Up The Day Job”. We both laughed. Self-depreciating humour is the best form of defence sometimes. Maybe I should just forget about all this economics stuff and stick to being a sound engineer.

For those who were willing to engage in my recessionary blabber, the overriding pushback I received was the continued strength of the labour market. This is true. Unemployment rates in most developed economies are at historic lows. You simply can’t get enough workers to fill the roles that are available in many sectors.
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The thing to remember about the jobs market though is that unemployment tends to remain really strong right up to the point where a recession takes place. Check out the graph below. The shaded areas are recessions. Notice how close to full employment (4%) the economy was just before each recession occurred. 7 out of the 12 recessions occurred when unemployment was either 4% or lower. Out of the remaining 5 recessions, 4 occurred when unemployment was just 5% and the 1981 recession occurred when unemployment rate was a little over 7.5%.

Cast your mind back to 2008 and how that crisis took most people by surprise. Overnight as global economies collapsed, unemployment rose sharply from 4%-10%. The recession prior to 2008 was the dotcom crash in 2000. US unemployment rose from 4%-6% between 2000-2003. During the 1989 recession, unemployment rose from 4%-7.5% between 1989-1992.

As a business owner I know first-hand how difficult it is to postpone hiring when demand for your services is still strong. When the general sentiment is positive and sales are up, it’s hard to ignore these feel-good factors. Your natural instinct is to invest and drive forward, even when in the back of your mind something’s telling you that trouble could just be around the corner.

Trying to time these downturns is extremely difficult too. Most businesses live ‘in the now’ either way. Making job cuts in advance of a recession, which may or may not occur, is very rare. I was initially critical of the tech sector for over hiring during the pandemic but in hindsight they didn’t have much of a choice. Very few companies turn down work when it’s there for the taking. Hence, unemployment is a backward looking indicator. As most economists would agree, it's not a reliable barometer for forecasting future growth.
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In the recession cases I outlined above, the common denominator that caused these downturns was tight monetary policy and rising interest rates. Ring any bells? The graph below charts the path of interest rates in the US since 1960. Again, the shaded areas are recessions.

In all cases, interest rates (blue line) were rising just as those recessions were occurring. You’ll notice too that every recession required lower interest rates as time went on. This is shown by the blue line trending downwards from around 1980. The reason being that government debt has been rising higher and higher ever since. Now check out the next graph showing total government debt in the US for the same period. As you’d expect, it’s basically the inverse of the interest rates.

If you zoom in a little on the interest rate graph you’ll notice how the rise and fall of interest rates occurs within smaller business cycles, usually lasting approximately 10 years from peak to trough. At the start of each cycle, central banks cut interest rates in response to a recession, print money and buy government debt. Banks create loans and businesses and consumers start borrowing. Towards the end of the cycle where we are now, too much debt accumulates relative to incomes and GDP and the economy reaches its capacity limits. Asset bubbles form in financial markets, house prices soar, and central banks intervene to cool the economy by raising rates. As you’ve probably guessed, the business cycle is manipulated to great effect by central banks from start to finish.

While the debt ceiling fiasco in the US has been resolved, the treasury department now needs to issue $1.3 trillion worth of bonds for the remainder of the year so the government can start spending again. An increase in the supply of bonds reduces bond prices and pushes yields higher. This is exactly what the banking sector and financial markets want to avoid given the damage caused by falling bond portfolios earlier this year. Bond yields could rise higher still, given that both the Fed and the ECB have not ruled out further rate hikes in 2023 as they battle inflation.

My own view is that inflation will continue to ease this year; but still, at 6% the ECB has a ways to go before reaching their 2% inflation target. Barring an emergency, I can’t see interest rates in the Euro area falling any time soon. As indicated by the ECB itself, interest rates are likely to continue climbing towards 4% between now and the end of the year. From that point the ECB, similar to the Fed this week, will probably pause, assess the data, before deciding its next move. Research by the Central Bank of Ireland in April of this year shows that 70% of Irish mortgages will no longer be insulated by lower fixed rates by the end of 2024. The race is on to get inflation down asap.

I think we are likely to see a more gradual unwinding of the economy in the meantime either way. Most businesses are reporting weaker demand and reduced activity levels for the first time since 2021. If revenues fall to pre-pandemic levels, many companies will struggle to cover their costs. This will naturally lead to widespread job losses in many sectors. Tech companies were not alone in over hiring. The Financial Times reports this week that approximately 11,000 banking jobs could be lost in 2023. I fear that this is just the beginning of more job losses and insolvencies over the next 12 months. Despite labour shortages, when business activity falls the demand for labour falls with it. I can’t see labour 'hoarding’ protecting the unemployment rate as soon as companies start to lose money.

As the unemployment rates starts to creep up, the general mood in the economy will become more pessimistic. Once this pessimism gets imbedded in the system it’s very hard to reverse. Unemployment usually rises for at least 2-3 years before eventually levelling off. Business investment falls, households start saving and the government’s message turns more negative.
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At $300 trillion, total government and corporate debt in the world economy is currently 28% higher than its peak in 2007. Something has to give. Remember, we are in a cycle, a cycle that began a long time ago in 2008. We shouldn’t be too surprised if things get a little hairy from here. Hold on to work if you have it. I won’t be giving up the day job any time soon.