A Framework That Provides Clarity

During periods of “low visibility,” confusion reigns: for every indication of one trend, there seems to be a countertrend. The key is to glean from the collective wisdom of reliable leading indicators a clear signal that the economy is headed for a turn.

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Jan 02 2018

Fracking: The Great Destabilizer

ECRI’s understanding of what causes a recession has long differed from conventional wisdom, which holds that recessions result from unexpected shocks that then propagate through the economy. In contrast, we believe that endogenous cyclical forces periodically open up windows of vulnerability for the economy, and that it’s within such windows of vulnerability that negative shocks can trigger a recession. Because negative shocks tend to arrive sooner or later, an economy’s entry into a susceptible state is almost always followed by recession.

But a typical source of negative shocks has been flipped on its head. In recent decades, recessions were often triggered by oil price spikes in the wake of Fed rate hike cycles. However, thanks to the fracking revolution, the U.S. has now become the third-largest producer of crude oil, making it somewhat immune to the recessionary oil price shocks seen in earlier years.

On the flipside, the U.S. economy is now much more dependent on crude oil production. This is evident from the chart, which shows the six-month trailing average of the growth rate of the crude oil extraction component of industrial production (IP).

From the early 1970s through the Global Financial Crisis (GFC), IP crude oil growth was mostly negative. Indeed, U.S. oil production fell by more than half between 1972 and the GFC lows. But, following the GFC, it has more than doubled, going back to about where it was 45 years ago.

It is undeniable that – as the chart shows – the size of the swings in oil production growth are now far larger than they used to be. This demonstrates that the economy has become more dependent on a sector that is inherently volatile, and a new source of economic instability.

In this context, please recall our recent piece about the decline in the volatility of GDP growth. We reported that, unlike low trend growth, which “is mostly set in stone by the simple math of potential labor force growth and productivity growth, … the volatility of economic growth can rise quickly.”

Today, with the U.S. more reliant on oil production in the years since the GFC, a sharp drop in the price of oil could raise the volatility of economic growth and, in turn, the risk of recession.

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