Past recessions are not a guide to the future

The Bank of England is hiking rates in the face of a stagnant economy & inflation (‘stagflation’), while the US is experiencing a slowdown unlike any before.

Press coverage:
Investment Week: Past recessions are not a guide to the future

Interest rates in the UK now stand at 1.75%, after a 0.5% increase from 1.25%. Policymakers likely deemed it necessary to go further than the 0.25% ratcheting-up approach they had stuck to thus far and send a message that they took the threat of inflation as seriously as the US Federal Reserve (Fed) – which has been far more aggressive (more on that below).

The Bank of England now expects UK GDP to fall for five consecutive quarters starting later this year, and yet still chose to choke off economic activity by making borrowing more expensive.

Traditionally, central banks cut interest rates when they foresee gloom ahead. That they opted instead to raise them in the face of such a bleak outlook speaks to the level of importance they attach – understandably – to putting a lid on any feedback loop between wages and prices (where each drives the other higher and higher) before it takes off.

Capital Economics expects the Bank of England will need to keep increasing the rate until it reaches 3% to achieve the effective dose. Of course, much is uncertain, but it is plausible that, once this level is reached, rates will then be reduced swiftly – and we can only hope things get back to something resembling normality.

We’re not in Kansas anymore

While undoubtedly a great many people here in the UK will suffer financial hardship in the face of astonishing energy bills and an uptick in mortgage repayments, we have to remember that globally diversified portfolios still largely dance to the tune of the US economy.

The Fed recently increased interest rates by 0.75% to a range of 2.25–2.5%. Its alacrity in taking a more hawkish stance in taming inflation goes a long way to explaining the dominance of the dollar so far this year.

However, strange things are afoot. Ostensibly the US is in a slump, having suffered two consecutive quarters of GDP contraction. And surveys show consumer confidence has been dented by the cost of filling up at the pump.

Yet, on the other hand, unemployment is still at record lows, and private sector employment, in particular, is now above pre-pandemic levels. Business activity is, for the most part, humming. What kind of recession is this?!

Running hot

A crucial part of the answer lies in the US jobs market. With the employment participation rate still about 1–1.5% below pre-pandemic levels, the US economy faces a situation of too much demand for labour and not enough supply.

The number of job vacancies now being advertised stands at an extraordinarily high level. Hiring took a nose-dive as Covid-19 hit but then rebounded with great force once restrictions were lifted. President Biden’s fiscal stimulus added a perhaps not entirely necessary turbo charge.


Recently, a rather public disagreement has kicked off between some big names in economics (among them Larry Summers, former US Secretary to the Treasury under President Clinton) and the Fed.

There’s more than a whiff of ‘my model’s better than yours’ about this to-and-fro, but the crux of the matter is whether it’s plausible for inflation to be brought under control without a significant uptick in unemployment.

Summers and co. assert that it’s not. They argue that the only way it could happen would be if job-matching efficiency increased, or if fewer people quit their job to take up another. Ultimately, they say, a marked decline in vacancies without a corresponding increase in unemployment has never happened before – so we shouldn’t bank on it.

The Fed is more optimistic. Its analysis indicates that only a modicum of hiring plans need be shelved for there to be an outsized calming effect on inflation – and thus there is no cause for concern that widespread unemployment would result. Moreover, it retorts, unprecedented things can and do happen.

It’s different every time

Of course, only time will tell who is right. But the Fed is surely correct in its rejection of history as a guide to the future.

The key point is that arguments from induction – ‘it has never happened before, so it never will’ – are weak. Unfortunately, the investments industry is replete with them – despite that familiar performance warning from regulators.

After all, empirical data didn’t permit a year starting with a ‘20’ until it happened. What we need instead, as the British physicist David Deutsch has written so compellingly, are specific, hard-to-vary explanations that both agree with the evidence we have of what has happened in the past but are capable of reaching beyond it.

Investment conclusion

The path of interest rates – and hence the outcome of the war on inflation – is still the predominant force driving asset prices.

Arguably, share prices have already factored in the potential for economic malaise to dent corporate earnings. The downward lurches of stocks like Walmart and Target, which both shed almost a quarter of their market value within hours of releasing dour company results, could almost be seen as a sped-up slow-down – market analysts collectively scribbling out ‘normal’ in their calculations and pencilling in ‘recession’.

Consequently, we’re left in hock to central banks once more. And bizarrely, therefore, bad news becomes good news – if business activity appears to dim or job offers are rescinded, inflation expectations fade and the path of interest rates becomes a little less steep. Both stocks and bonds appreciate (the irony).

Still, in spite of it all, the case for long-term investment – which has nothing to do with near-term prospects ­– remains as strong as ever. Whether the recent rebound in share prices marks a turning point, or we suffer another leg down, it’s still unwise to time the markets, and they’ll likely be out of sight in ten years.

Important information
Past performance is not a guide to future returns. Please note that the value of investments can go down as well as up, and you may get back less than you originally invested.