Just how deep will the US recession be?

Readers of this blog will know that I have worried about this issue for many months now.  

Here are two more charts which strongly suggest that a deep recession is possible.   They show data back to 1970.

The first chart shows the 12-month change (absolute, not percentage) in the Fed Funds rate.   The Fed Funds rate is the rate the Federal Reserve Bank charges for overnight borrowings by banks from the Federal Reserve system.  It is the bellwether which sets the level of interest rates in the market.   In the chart, I have plotted it upside down, because when interest rates rise, the economy slows, and when they fall, the economy accelerates.  I have also moved it forward, that is, I have plotted it with an 18-month lag, because it takes a long time for the change in rates to take effect.  

The QCI is a monthly coinciding index (i.e., it coincides with the business cycle), which closely tracks real GDP.

Notice how close the relationship between the change in rates and economic activity is, except for the GFC (2008/2009), where the downturn was materially worsened by the half-witted orgy of ill-advised mortgage lending by the banks in the years prior to the Fed raising rates.  The inevitable hangover took down the banking system and everything else with it.

The other apparent break in the relationship was caused by the Covid Crash of early 2020.  This also caused the spike in the QCI in early 2021 via the year-on-year calculation.

The rise in rates (shown in the chart as a fall, because, remember, it's inverted) is consistent with the deep recessions of 1973-1975 and 1980-1982.  The only good news is that this indicator (the inverted change in Fed Funds) is bottoming---provided the Fed doesn't raise the Fed Funds rate from now on.

Click on chart to see clearer image

The second chart shows the rate of change in real (i.e., after allowing for inflation) money supply.  The data for both M1 and M2 appear to have been distorted in early 2020 by a definitional/regulatory change by the Fed affecting the classification of chequing and savings accounts.   It's partly this change which may have caused the spike in the year-on-year rate in 2020/21.  But the spike was prolly also caused by the Fed flooding the system with liquidity.  However, this distortion is now passed.

Real money supply is falling faster than it has done at any time in the last 63 years (1960-1970 not shown in the chart).   It's falling faster than it did before the 1973–1975 and 1980–1982 recessions, and they were, before the GFC, the deepest recessions the USA has experienced since the Great Depression.  The implication is that the US is likely to experience a recession as deep as those two.  In other words, not a "soft landing".    See this interesting analysis from Reuters.

Click on chart to see clearer image.
Note: money supply charts not plotted with a lag.

So I remain sure that the US will experience a recession this year, with a peak-to-trough fall in real GDP of 3-5%, and a rise in the unemployment rate of 5-6%.

What could prevent these outcomes?   Well, Covid has distorted many indicators, and many economic relationships.  So time-honoured linkages and drivers may no longer work.  I think that, though possible, this is very doubtful.  

Of the Big 8, the US, Europe, the UK, Brazil and Russia are themselves likely to go into recession or are already in one this year.  China is rebounding, and India is still growing strongly.  On balance, the rest of the world won't save the US.  In the past, it usually went the other way---US recessions transmitted themselves to the rest of the world.   (The China rebound will likely reduce the depth of Australia's recession, though our Reserve Bank has also raised rates by too much.) 

During the 1973-1975 recession, the S&P500 fell by 44% peak to trough.  During the 1980-1982 recession, it rose at first before falling by 20%.   During the GFC, it fell by 57%.  However, the banks are much better capitalised now than they were when the GFC began, and the kind of financial crisis we experienced then is less likely (but by no means impossible) today.  So far this cycle, the S&P500 is down just 14%.  The risks, surely, are on the downside.