When will the US economy enter a recession?  That question can be answered with the answer to another question: “When will the U.S. banking regulators curb risky banking practices?”

Saying or writing the word recession is like crying WOLF! No one cares and no one is preparing for a real economic downturn.  Financial experts and economists endlessly debate the possibility of a recession but don’t seem to understand the basics of money. 

The main recession indicator that started economic minds talking was the inversion of the yield curve. Pundits are correct in attributing significant weight to the inverted yield curve as an indicator. The New York Federal Reserve’s Recession Probability Indicated is based on the inversion of the yield curve.

As seen in the graph above, the most recent Fed calculations estimate that there is now a 61% probability of a recession. This assessment is based solely on the inverted yield curve. The question isn’t really will there be a recession, the key question is when will the recession hit?  Even the Conference Board’s Leading Economic Indicator Index is flashing signs of recession.

Analysts fail to understand the time needed for the giant U.S. economy to respond to economic factors.  Since 1980, the economy has responded with differing lags to the inverted yield curve.

The 10 Year Constant Maturity Treasury vs. 3 Month Constant Maturity curve inverted in October 2022. Based on the average lag of 13 months seen in previous recessions, we should expect to see the recession start thirteen months after October 2022, or in November 2023.  The longest lag between curve inversion and recession was 18 months – this would put the onset of the recession in April 2024.

However, as avid readers of my blogs know, the Federal Reserve has succeeded in curbing the growth of the money supply.  M2, the key measure of money supply as measured by currency, coins, checkable deposits, and travelers' checks, stopped increasing in March of 2022 and has been falling until May 2023.   Deposits in the U.S. banking system also started dropping around the same time.  A drop in M2 and bank deposits is often sufficient to trigger a recession in a normal economy when the velocity of money is near a stable equilibrium point.

As discussed before in my previous articles on the velocity of M2, the real causes of inflation, and the Quantity Theory of Money, GDP is equal to M2 times the Velocity of M2. The graph above shows that the velocity of money dropped off a cliff in the spring of 2020 to almost 1.0.  Velocity was clearly going to rebound to previous levels in an economy with a Fractional Reserve Banking System, but economists rarely mention this situation.

The Velocity of M2 is being driven by three factors: the positive sensitivity of the bank Loan-to-Deposit Ratio to increasing interest rates, the banking sector’s desire to continue lending out money even when deposits are falling, and the need for a new equilibrium for Velocity of M2 in a growing economy.

The graph shows the relationship between the Loan-to-Deposit ratio versus Real Yield (yields after the inflation component is removed).  With real yield at 1.1% according to Federal Reserve data, we would expect the Loan-to-Deposit ratio to be around 80% (or 0.80) according to the graph (the current observation left blue diamond of the two that are significantly below the predicted line.

Looking at the current Loan-to-Deposit ratio of 72%, the current Velocity of 1.29 is just below the equilibrium point of 1.31.  However, as we saw in the previous graph, the Loan-to-Deposit Ratio should be around 80% and this would imply an equilibrium velocity of roughly 1.45.   The most recent GDP reading was $26.8 trillion, which is the product of a Velocity of 1.29 and M2 of $20.9 trillion.  If the equilibrium relationship holds and M2 stays at $21 trillion, then we would expect GDP to grow to $30.3 trillion, an increase of 13%.  If Velocity stays on its current growth track, it should reach 1.4X in February 2024.

Two developments should curb the growth of the Loan-to-Deposit Ratio in early 2024:

1.      The Federal Reserve, the Office of the Comptroller of the Currency, and the FDIC issued a new proposal that would revise the measurement of risk-weighted assets and the definition of regulatory capital. The net result would be a ceiling on the Loan-to-Deposit ratio and the ability of banks to increase profitability with growth in their loan portfolios relative to underlying deposits.

2.      Smart banks will voluntarily cut back loan growth when the Loan-to-Deposit ratio reaches the point where their reserve requirements have hit a ceiling, and their asset/liability risk models signal warning signs.

Conclusion

The recession is coming, the Federal Reserve might be able to engineer a mild recession, but there will be a recession since the Federal Reserve Open Market Committee will need to continue raising rates to curb inflation.  The increase in real yields will drive loan growth in relation to deposits which in turn will spur the economy and require even more rate hikes by the Federal Reserve.

In 2024, Loan-to-Deposits and the Velocity of M2 will reach equilibrium, and both the Velocity of Money and the Loan-to-Deposits will stop climbing.

One outcome is almost certain, when the Velocity of M2 reaches equilibrium, GDP will fall as it tracks the declines in M2. The National Bureau of Statistics will then declare that the U.S. Economy is in recession.