Will the RBA tip us into a Recession?

A sun-shower recession

With inflation and interest rates soaring the question on everyone’s lips is whether the RBA will push the Australian economy into a recession. 

There are two broad theories of why a hypothetical recession might occur:

1. The RBA will err and overshoot the landing zone pushing unemployment too high (ie above the NAIRU) and cause the economy to contract.

2. Long term inflation expectations will become unanchored and rise above ~4 per cent and thus the RBA will be required to engineer a recession to return to the 2-3 per cent target band.

I think the second hypothesis is unlikely. Inflation expectations remain remarkably anchored so far with both financial markets and economists generally expecting inflation 2 years out to close to the target band. Even in the US, which has much more serious inflation problem, the Federal Reserve’s long term credibility remains intact.

But is there a chance that the RBA will accidentally cause a recession?

A Sunshower Recession

Here it depends on what you mean by the term recession. The Sahm Rule (created by Claudia Sahm) predicts that if the unemployment rate rises by 0.5 percentage points over a 12 month period then a recession will occur. The Sahm rule isn’t a perfect fit for Australia but it is a reasonable guide.

Imagine then if the RBA were to return the unemployment rate to a plausible NAIRU of 4.5% from its current rate of 3.9%. Assuming this occurred in a 12 month period then this would involve triggering the Sahm rule recession indicator - even with the perfect soft landing that involved zero overshooting of the equilibrium!

Would such a rise result in the economy contracting? Probably not if the RBA engineered a soft landing, but it is certainly possible if the RBA overshot the NAIRU-landing zone. The RBA’s most recent (although by now out-dated) forecasts indicate that growth in late 2023/early 2024 will slump to ~2% and that unemployment will decline to around 3.6%. 

Clearly this picture is going to change when a new round of forecasts are issued in a month's time.  But if we were to pencil in a 1 percentage point increase in the unemployment rate to ~4.9% instead of a continued decline, then that would likely push GDP growth close to zero if not below it.

That could paradoxically still leave us with an unemployment rate still starting with a 4 - but an economy technically in recession!? This would be the equivalent of an economic sunshower, a slowing economy while the unemployment remains historically quite low.

If the NAIRU ends up being a little higher than 4.5 per cent or the RBA overshoots the target then the economy could well tip into a contractionary period even if all that means is that the economy is returning to its long run equilibrium after a particularly hot period. 

Such an outcome is still unlikely - Okun’s Law relating changes in unemployment and GDP growth could be a poor description for our newly overheated economy. But given our newfound appreciation for the level of uncertainty the future can bring I don’t think it can be ruled out by any means.