Recession Risk Is Low, Says CBS Professor Abby Joseph Cohen

When Professor Abby Joseph Cohen studies the data, she doesn’t see the US economy heading into a recession — despite the ongoing pressures of inflation, rising interest rates, and a spate of high-profile layoff announcements.

“What it boils down to is that the US consumer is actually now in pretty good shape,” she says.

Cohen, a professor of business in the Economics Division at Columbia Business School, has spent her career analyzing the economy, most recently in her role as senior investment strategist at Goldman Sachs.

In the interview below, she shares her insights about the risks of ongoing political negotiations about raising the debt ceiling, the effects of a prolonged period of low interest rates on asset valuations, and how the markets exhibit confidence that the Fed has inflation under control.

CBS: What are the implications of a divided Congress on government debt and the limits the Treasury faces after having hit the so-called debt ceiling in January?

Abby Joseph Cohen: We’ve had divided Congresses before. What’s different in this situation is that there are individuals mainly on the Republican side of the aisle who have made very public statements that they do not oppose shutting down the government. Several have said that pushing the US Treasury into default is not off the table. The members of Congress who waited until the end to support Mr. McCarthy’s election as Speaker, and to whom he may be beholden, include those who may prefer to disrupt government rather than to make sure it moves smoothly. It’s a positive sign that Speaker McCarthy met with President Biden on February 2 to begin their discussions.

CBS: How do you see this new uncertainty unfolding in the debt markets?

Cohen: The debt markets will be watching this with increasing attention. The Treasury has been using so-called special measures since the third week of January to make sure that there is cash to pay the Treasury’s bills. Most analysts expect that the Treasury will have depleted these special adjustments some time between June and September. The actual date will depend upon a whole host of factors, including how robust tax receipts are in the month of April. If those tax payments are stronger than currently expected, then the Treasury might have a little more running room.

But I think that investors will become increasingly concerned as we get closer and closer to June, especially if the political heat doesn’t get dialed down. Right now, debt market participants are well aware that the debt limit has been raised 78 times since 1960. And only once was there the real threat of a default, which was led by the Tea Party in 2011. I worry this may be the second time that we face a real threat. There are too many current members of Congress who seem willfully ignorant of the consequences of a default on the US and global financial markets.

CBS: What stands out to you from that time?

Cohen: Investors in the bond markets took the threat to heart. Interest rates rose notably in the US Treasury market. Curiously, the ratings agencies didn’t downgrade US debt until after the interest rates had already gone up. The bond rating agencies confirmed the damage after the fact and belatedly acknowledged something that the bond market participants had already recognized and priced in. And I would expect something similar to happen this year, if we get that sort of brinkmanship.

CBS: So do you see the efficient market theory playing out again, where these potential risks will get priced in?

Cohen: We like to think that markets are efficient, but they aren’t always. In this year’s debt drama, much is out in the open and investors are already aware of how fraught the negotiations may be within the Congress as well as between the Congress and the White House. Several members on the Republican side have thrown down the gauntlet within their own party on topics such as Social Security and Medicare and Medicaid payments. But investors are basically saying that there is still time to negotiate a way forward on raising the debt ceiling.

CBS: When you consider these political uncertainties as well as other risks such as inflation and a rising interest rate environment, how should they be weighed when considering asset valuations?

Cohen: We have seen the end of a long-lasting era in which inflation and interest rates were declining followed by a relatively stable environment. That was incredibly unusual. It lasted more than 30 years. Since the 1980s, we went from high inflation to moderate inflation to low and stable inflation; interest rates followed along. Interest rates in the 1970s and 1980s were often in the double digits. In recent years, rates have reached low single-digit levels, including for mortgages and auto loans. In some cases, even in the US, real interest rates (nominal rates adjusted for inflation) have actually been negative. Several major economies have also seen negative nominal interest rates, an unprecedented situation.

CBS: What does that tell you?

Cohen: Investors were confident that inflation would not be a problem. Basically, money was free. When the cost of capital is zero, then all kinds of things can happen in both the financial markets and in the real economy. When money is free, companies, households, and investors are very happy to borrow and then to use that free capital to make investments or to lever up the investments that they have. When interest rates start to move up, the arithmetic of decision-making has to change.

CBS: What is your outlook for households and individuals?

Cohen: When the economy is considered to be “too strong” and inflation is “too high,” one of the tools used by the Federal Reserve is higher interest rates. Some sectors in the consumer economy are very credit sensitive. Consumer purchases of big-ticket items such as housing and automobiles are typically financed with loans.

Housing demand is usually very sensitive to mortgage rates. Because of the pandemic, we’ve had a very peculiar housing cycle as many people decided to move their young families out of the cities into the suburbs or into larger homes, perhaps sooner than they otherwise would have done. Demand for new housing was much stronger than would have otherwise been expected in 2020-2021. Housing prices have been a major contributor to overall inflation. By raising interest rates, the Fed has seen a slowdown in demand for mortgage borrowing, and housing demand has also slowed. Home prices have fallen in some areas.

Because of the pandemic-hastened move toward the suburbs, and reluctance to use public transit, there was unprecedented demand for autos, both new cars and used cars. The prices of both moved dramatically higher. For several months, these were the largest contributors to the rapid rise in the Consumer Price Index (CPI). Demand for autos is among the items that usually respond very quickly to higher interest rates. Price inflation in autos has been dramatically reduced over the past year as demand has eased and supply chains have become unstuck.

Credit cards are another piece of the puzzle. Homes are typically bought on credit; autos are typically bought on credit; and a credit card is typically used for smaller purchases. In many ways, they’re all related. Interest rates go up, and most households decide that they’re going to spend at a slower pace.

CBS: How did it play out in the financial markets?

Cohen: In the period of very low-cost money — free money for many borrowers — there was a willingness to take on debt. In the corporate market, there was a huge increase in the amount of debt taken on, including by companies that didn’t need it but recognized an incredible opportunity to lock in free money for a long period of time. Why not borrow if the cost is something close to zero? This low cost credit also fueled a great deal of private equity activity, venture capital activity, and so on.

In addition to the very high-quality companies that borrowed long to take advantage of the low interest rates, we also saw some companies that were, from an operating standpoint, not quite so strong, taking on more debt and trying to leverage their results. Their operating profit margins were not quite so robust, but they wanted to enhance the bottom line, and they did that by borrowing.

Many investors did the same thing. To use a very simplistic example, let’s say a money manager was generating a 5 percent return, but if they levered up using very inexpensive capital, say, two to one, they could report a 10 percent return to their investors. Higher interest rates push up the cost of capital and leverage becomes less appealing. Deleveraging is also possible. For some borrowers, a related and very critical question is whether capital will even be available, especially for lower quality borrowers. As rates rise, many lenders become more cautious.

CBS: What is your outlook on what these dynamics mean for financial markets and asset values?

Cohen: Something else happened during this period of low inflation and low interest rates. The risk premium — that is, the “extra” return investors expect to receive above the Treasury risk-free rate — was dramatically compressed. In 2021, before the Fed started to raise interest rates and before Treasury yields began to rise, the risk premia on other credit instruments were also exceedingly low. For example, you expect triple-A credits, high-quality corporates, to be able to borrow at yields not much higher than the Treasury. But one of the odd things that happened was that lower quality companies and other borrowers were also able to access very low rates. It’s an indication that many lenders weren’t demanding very much extra return despite the extra risk involved. Sovereign borrowers in other countries were able to borrow for rates and yields that were not much different from the United States or, in some cases, even lower, an indication that risk may not have been appropriately priced.

There were also concerns that duration, or time risk, was not being appropriately priced. Typically, the longer the period of the loan, or duration of a bond, the higher the rate. But capital markets were not pricing in much extra risk even when moving out several years along the yield curve.

Much has changed since the end of 2021, when the Fed became more aggressive about raising interest rates. First, the entire yield curve has shifted upward as interest rates have moved higher throughout. Second, credit spreads have widened, reflecting differences in the perceived credit quality of the borrowers. Third, lenders in both public and private transactions have become more diligent and some capital flows have been reduced.

CBS: What are yields telling you about how the market is pricing in risk?

Cohen: We have seen something very interesting happen to the yield curve in recent months: The yield curve now is somewhat inverted. The short-to-intermediate yields that the Treasury must pay to borrow money are actually higher than the long-term yields. The standard rule of thumb — which I think is not right currently — is that the Treasury yield curve inverts only when there’s going to be a recession. Investors think, “Oh my gosh, interest rates are so incredibly high, the Fed is going to put the economy into a recession in order to slow things down and bring inflation under control.” And they will use this as an argument for why some of those longer Treasury yields are below the shorts and intermediate.

Although nothing is certain, I do not think there’s going to be a recession. So what else could this inverted yield curve mean? It could simply be a vote of confidence that the Federal Reserve is paying attention to inflation — and that what they have done thus far and what they’re likely to do will be enough. Investors think that the Fed is really on the case and they’re not going to let inflation move out of control.

CBS: What gives you confidence there won’t be a recession?

Cohen: What it boils down to is that the US consumer is actually now in pretty good shape. Unemployment rates are quite low and new jobs are still being created at a solid pace. The data released on February 3, showing more than 500,000 new hires in the last month, surprised most economists on the upside. In addition to that, we have a situation that is rarely if ever seen, not just in the United States but in any economy: There are many more open jobs than there are available workers. That suggests to me there is wiggle room if economic growth does slow a bit. There are still lots of jobs out there.

Now that doesn’t mean that everyone will keep their job. In our economy, there’s always this friction; in any month, there are many people who are losing their jobs while others are getting new jobs. And right now, there is much public attention being paid to the jobs that are being lost in the technology sector, in notable contrast to the rapid hiring in prior years by these companies. But thus far, if you add up the public announcements from technology companies about the numbers of people who will be losing their jobs, the running total is on the order of 250,000. That’s obviously very painful for these individuals. But when we put it in macro perspective — and again, I don’t mean to minimize these losses — this is an economy that has been creating 200,000 to 300,000 new jobs every month, on average, and more than 500,000 last month alone.

Another important factor for households is the relative good health of their balance sheets. The monthly debt repayment load relative to disposable personal income is at one of the lowest levels ever seen. And while some families may be overextended, the median family is in good financial condition.