Powell, Greenspan and Whatever it Takes

Doug Nolan

Fed Chairman Powell is in a tough spot, one made no easier now that he's on the receiving end of disapproving presidential Tweets. The global Bubble has begun to falter, which only exacerbates divergences between various markets and economies. The U.S. is booming, while China struggles and EM economies now stumble into the dark downside of an epic cycle. The U.S. economy and markets beckon for tighter financial conditions, while higher U.S. rates pose significant danger to fragile global markets already confronting a major tightening of financial conditions.

Powell played it safe in Jackson Hole. I imagine he'd have preferred to sit this one out. As such, his presentation was too heavy on rationalization and justification. The FOMC is trapped in Greenspan-style "baby steps," and it is curious that the Fed Chairman would choose to praise Alan Greenspan for his nineties policy approach:

"Under Chairman Greenspan's leadership, the committee converged on a risk-management strategy that can be distilled into a simple request: 'Let's wait one more meeting; if there are clearer signs of inflation, we will commence tightening.' Meeting after meeting, the committee held off on rate increases while believing that signs of rising inflation would soon appear. And meeting after meeting, inflation gradually declined."

If the Greenspan Fed had in fact adopted a "risk management strategy," it was a failed attempt. It's too easy these days to disregard the highly disruptive boom and bust cycles that have been prominent in U.S. and global markets (and economies) over recent decades. And here we are today, the Federal Reserve still accommodating Bubble Dynamics because of its failure to respond to financial developments and contain excess back in the nineties.

The bursting of the nineties "tech" and corporate debt Bubbles spurred the Greenspan Fed to cut rates to 1% by June 2003. At that time, double-digit mortgage Credit was already fueling self-reinforcing home price inflation. Short rates were then "baby stepped" upward until June 2004 and remained below 4% all the way into late-2005. The lesson not learned from that episode was that small, gradual telegraphed rate increases are ineffective in the face of an inflating Bubble. Such a policy course ensured a progressive loosening of financial conditions when tightening was clearly required from a risk management perspective.

Accommodating the nineties Bubble basically ensured the Greenspan Fed would later adopt even more aggressive post-Bubble accommodation. Indeed, the Fed specifically targeted mortgage finance as the source of reflationary Credit. This greatly compounded the fateful error from earlier in the Greenspan era: nurturing market-based Credit and financial speculation in response to banking system impairment following the collapse of late-eighties ("decade of greed") Bubbles.

The financial world changed momentously during the nineties. Out with the staid bank loan, in with dynamic market-based finance: Asset-backed securities, MBS, GSE Credit, money-market funds, derivatives and Wall Street "structured finance". In with repurchase agreements ("repo") and essentially unlimited cheap market-based securities Credit. In short, out with reserve and capital requirements that traditionally restrained Credit growth; in with unfettered asset-based finance the likes the world had never experienced.

From Powell's opening paragraph: "Fifteen years ago, during the period now referred to as the Great Moderation, the topic of this symposium was 'Adapting to a Changing Economy.' In opening the proceedings, then-Chairman Alan Greenspan famously declared that 'uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape.'"

The Fed and global central banks never successfully adapted to the new paradigm they themselves had championed. Unfettered market-based and speculative finance beckoned for more stringent monetary management. Yet the Fed, fretting the instability and associated uncertainties, erred on the side of easy "money." And, despite it all, this error compounds to this day.

The "great moderation" period saw powerful inflation dynamics take hold throughout the securities and asset markets, at home and abroad. This new finance had a strong inflationary bias that created a propensity for inflating powerful Bubbles. Asset inflation and Bubbles emerged as the most consequential form of inflation, yet central banks were too content to take Credit for the so-called "great moderation" in consumer price inflation (that clearly had much more to do with profound changes in finance, technologies, globalization and the nature of economic output - rather than effective monetary policy).

As the nineties unfolded, policy focused on the "real economy sphere" - the New Paradigm, electrifying technological innovation and the so-called "productivity miracle" - along with various measures omnipotent central bankers would employ to support such obviously constructive advancements. Policymakers should have instead been fixated on momentous "financial sphere" developments, and how the associated structural loosening of financial conditions warranted a counterbalance of tighter monetary policy and more stringent regulation.

Adopting the view that the New Paradigm favored a more permissive approach to monetary management, Greenspan got it dreadfully wrong. In the end, perhaps the most consequential analysis in the history of central banking was deeply flawed. The "maestro's" asymmetrical monetary policy approach was instrumental in bolstering inflationary psychology throughout the markets, with the Greenspan "put" repeatedly resuscitating vulnerable Bubbles. All the while, huge infrastructure was being erected to support the worldwide enterprise of financial speculation, and the Greenspan Fed gave an enthusiastic thumbs up.

Ironically, the free-market ideologue sowed the seeds for unsound markets increasingly incapable of self-correction and adjustment. Asset inflation: the most dangerous form of inflation specifically because there are powerful constituencies beholden to it and essentially none in opposition.

In the sixties, Alan Greenspan was said to have explained to his fellow Ayn Rand colleagues that the Great Depression was the result of the Federal Reserve repeatedly placing "coins in the fuse box." Ironically, Greenspan initiated a process that has seen the Fed and global central bankers resorting to coins to circumvent market forces for going on three decades - culminating with "whatever it takes" directing the one-way, free-flow of "money" into the securities markets.

I try to cut Chairman Powell some slack. I understand he's trapped in gradualism and flawed central bank doctrine, more generally. But I was hoping he would over time initiate a retreat from the Greenspan/Bernanke/Yellen market "put." Powell: "I am confident that the FOMC would resolutely 'do whatever it takes' should inflation expectations drift materially up or down or should crisis again threaten." Why is this language necessary on a day with the S&P500 and Nasdaq trading to all-time highs?

Bond yields (and the dollar) dropped on the release of Powell's Speech. The market essentially presumes zero probability of the Fed ever aggressively tightening policy under any circumstance. Aggressive cuts and market support, well that's an altogether different story. I would argue that the prospect for a return of aggressive QE and zero rates is fundamental to ongoing extraordinarily low market yields and the flat yield curve. Greenspan's "asymmetrical" globally on steroids.

Low yields clearly support price Bubbles in equities, real estate and asset markets more generally. And the longer Bubbles inflate the more confident speculators become that future "activist" policy measures will bolster bond and fixed-income prices. The comprehensive "whatever it takes" central banking "put" provides unprecedented Bubble support - and, I would argue, amounts to yet another highly destabilizing and dangerous policy error. The egregious masquerading as conventional mainstream. To be sure, the problem with discretionary monetary policy is that one mistake invariably leads to the next bigger - and inevitably much bigger - mistakes.

"Changing Market Structures and Implications for Monetary Policy" is the theme for the 2018 Jackson Hole symposium. Pro-Bubble central bank monetary policy doctrine has for much too long been instrumental in fostering unstable market structures. Chairman Powell missed an opportunity to dial back the "whatever it takes" central bank approach to backstopping unsound securities markets. It's been a full decade since the crisis, for heaven's sake.

The nineties were on my mind throughout the week. An odd coincidence that Powell's Jackson Hole speech harkened back to Alan Greenspan and the nineties. In what is being called "the longest bull market in history," the duration of the current bull run this week surpassed the previous record, October 1990 through March 2000.

One person's record bull is another's greatest Bubble. GSE Credit and corporate debt were key sources of fuel for the nineties Bubble. And each bursting Bubble is to be reflated by a more formidable Bubble inflation. The post-nineties reflation was led by booming mortgage finance, much of it of the (money-like) "AAA" GSE and Wall Street structured finance ilk. The 2008 collapse of this much grander Bubble provoked unprecedented reflationary measures. This historic reflation went to the very foundation of global finance, sovereign debt and central bank Credit. It has corrupted the very heart of contemporary "money."

The problem with "money" is that it enjoys insatiable demand, creating the potential for extraordinarily dangerous Bubbles. "Whatever it takes" has deeply perverted market structure across the globe. Myriad risks have been inflated and totally distorted. Today's market view holds that central bankers will not tolerate a crisis. Perceived risk remains extraordinarily low, as illustrated by Friday's closing VIX price of 11.99. But true underlying risk is sky high and rising - market, economic, policy, political and geopolitical. Market structure and global imbalances, among others, are accidents in the making.

When this Bubble bursts, there will be no new source of "money" sufficient to fuel the next round of reflation. It's sovereign debt and central bank Credit for the duration. In the meantime, loose monetary policy will continue to accommodate an unprecedented expansion of government borrowings. As EM is now recognizing, the market mechanism for disciplining profligate borrowers doesn't function until it's too late. While the global Bubble falters at the periphery (Brazilian real down 4.7% this week!), boom-time excesses run unabated at the core.

Powell: "Whatever the cause, in the run-up to the past two recessions, destabilizing excesses appeared mainly in financial markets rather than in inflation. Thus, risk management suggests looking beyond inflation for signs of excesses."

A risk management approach would be working to extricate extreme central bank "activism" from the markets. Financial markets should stand on their own; the market mechanism needs to be operable. But rates, once again, remain too accommodative. Moreover, this is no time to be reminiscing about Alan Greenspan or trumpeting "whatever it takes." A missed opportunity Chairman Powell - and an important one at that.

The Unseen Risk in the Booming Loan Market

Low yields led investors to dive into loans but there are signs that the generalists are stepping away.

By Paul J. Davies

Central bank money inflated the markets for risky loans and the investment vehicles that buy many of them. Now, there are early signs of that driving force going into reverse.

In recent weeks, a growing share of new borrowers have had to lift interest rates on leveraged loans to win over investors. This might just be a touch of indigestion after several large deals to fund private-equity buyouts and takeovers, but some bankers think it is an early signal that liquidity is retreating from low-quality debt.

The trouble for borrowers isn’t rising debt costs today, but the risk that loans will be harder to refinance in future when investor money washes back to safer assets as yields improve. This matters because more than 40% of leveraged loans are typically used to refinance an existing loan. In the financial crisis, even some relatively healthy companies couldn’t refinance and had to reach deals with existing lenders to extend their debt.

Loans are popular right now because their yields adjust with interest rates, so they don’t lose money like fixed-rate bonds do during times of rising rates. The real problem lies in how investors who don’t normally buy loans will react to the end of quantitative easing, or central bank bond buying programs, which pushed them into risky loans in the first place.

As these programs unwind, more traditional fixed-income assets, such as government bonds and high-grade corporate debt, offer better yields. As bond yields recover to more normal levels and rate rises slow, investors won’t need to take risks on credit or complexity.

Higher rates will also likely weaken borrowers’ equity valuations and make debt a bigger chunk of their enterprise value. The same loan will thus look riskier, plus there will be less funding available if investors who typically buy bonds leave the loan market. That is when refinancing risk jumps.

The pushback on loan pricing began in spring, but has become more prevalent. One of the first big deals to suffer this year, according to bankers, was the $2.3 billion loan that is helping fund McDermott International’s takeover of rival engineer CB&I. Bankers had to lift the spread by 0.75 percentage points to 5% before investors would bite in April.

More recently, a string of loans have had to increase spreads by an average of 0.5 percentage points, according to data from S&P Global Market Intelligence’s LCD research service. In all, about 30% of new loans had to increase spreads during marketing in June and the first half of July—up from 12% in May.

This happened because fewer investors who don’t typically buy loans were bidding, according to bankers. Something similar also happened to new issues of collateralized loan obligations, the debt-funded vehicles that buy more than half of all new loans.

Loan pricing may have moved, but other terms remain very aggressive, by some measures more so than in 2007. Debt multiples on private-equity deals are as high as then at more than six times earnings on average, but investors complain that these earnings are often flattered by things like assumptions on cost savings. Also, the covenants that protect lenders by allowing them to act when things deteriorate have all but disappeared. They mostly still existed in 2007.

A pipelay vessel that belongs to McDermott International, whose attempt to takeover rival engineer CB&I was one of the first big deals to suffer from a loan pushback this year. Photo: Bryan van der Beek/Bloomberg News 

Worse quality loans means lenders will get less money back when defaults pick up. But even without defaults, the worry is that there won’t be enough lenders to cover borrowers’ refinancing needs in years ahead.

This could leave lenders little choice but to extend the life of loans on whatever terms borrowers can afford. Be careful what loans you buy now—you may end up stuck with them.

 Another Way Of Looking At The Pension Crisis, As “A Stealth Mortgage on Your House” 

Money manager Rob Arnott and finance professor Lisa Meulbroek have run the numbers on underfunded pension plans and come up with an interesting – and highly concerning – new angle: That they impose a “stealth mortgage” on homeowners. Here’s how the Wall Street Journal reported it today:
The Stealth Pension Mortgage on Your House 
Most cities, counties and states have committed taxpayers to significant future unfunded spending. This mostly takes the form of pension and postretirement health-care obligations for public employees, a burden that averages $75,000 per household but exceeds $100,000 per household in some states. Many states protect public pensions in their constitutions, meaning they cannot be renegotiated. Future pension obligations simply must be paid, either through higher taxes or cuts to public services. 
Is there a way out for taxpayers in states that are deep in the red? Milton Friedman famously observed that the only thing more mobile than the wealthy is their capital.  
Some residents may hope that they can avoid the pension crash by decamping to a more fiscally sound state. 
But this escape may be illusory. State taxes are collected on four economic activities: consumption (sales tax), labor and investment (income tax) and real-estate ownership (property tax). The affluent can escape sales and income taxes by moving to a new state—but real estate stays behind. Property values must ultimately support the obligations that politicians have promised, even if those obligations aren’t properly funded, because real estate is the only source of state and local revenue that can’t pick up and move elsewhere. Whether or not unfunded obligations are paid with property taxes, it’s the property that backs the obligations in the end. 
When property owners choose to sell and become tax refugees, they pass along the burden to the next owner. And buyers of properties in troubled states will demand lower prices if they expect property taxes to increase. 
It doesn’t matter if we own or rent; landlords pass higher taxes on to tenants. Nor does it matter if properties are mortgaged to the hilt or owned outright. In time, unfunded pension obligations will be reflected in real-estate prices, if they aren’t already. A state’s unfunded liabilities are effectively a stealth mortgage on private property. Think you can pass your property on to your heirs? Only net of the unfunded pension obligations. 
We calculated the ratio of unfunded pension obligations relative to property values in each state. We used 3% bond-market yields as our discount rate to measure unfunded obligations, because while other assets ostensibly earn a risk premium above the bond yield, these assets can also underperform.
Unfunded pension obligations range from a low of $30,000 per household of four in Tennessee to a high of $180,000 per household in Alaska. They amount to less than 11% of the average home values in Florida, Tennessee and Utah and more than 50% in Alaska, Mississippi and Ohio. 
There are a few surprises. California, Hawaii and New York have large unfunded obligations, but because property in these states is so expensive, the average household burden is less than 15% of the average home price. Meanwhile, West Virginia and Iowa have relatively low pension debts—but the average household obligation is more than 30% of the average home price because property is far less expensive in these states. 

On average nationwide, unfunded state and local pension burdens represent 20% of real-estate values. This ratio can rival or exceed an owner’s home equity, depending on the size of his mortgage. If real-estate prices adjust to reflect unfunded pension obligations, many homeowners’ equity could be at risk. As we’ve seen in Detroit, the public pension stealth mortgage can ultimately devastate the housing market.

This is yet another confirmation that we’re not nearly as rich as we think we are. If your home is your biggest asset but a big part of your equity is secretly claimed by the local government, you don’t really own it. And if you’re counting on a public sector pension and home equity to finance your retirement you might be hit with a double whammy when your pension is cut (despite what the state constitution says, it will be cut one way or another) at the same time your property tax bill soars to protect what’s left of pension benefits.

And the pension crisis is actually much worse than Arnott’s and Meulbroek’s research implies, because they’re using peak-of-the-cycle numbers. When the next recession brings an equities bear market, pension plans will lose money, causing their underfunding to explode. So that 20% stealth mortgage is about to get even bigger.

Cost savings keep Japan’s carmakers on upward road

Honda lifts forecasts and Toyota posts record results — as US rivals issue profits warnings

Kana Inagaki in Tokyo

Newly manufactured Honda cars ready for export in Yokohama, Japan © Reuters

Few international carmakers are bullish enough to raise their guidance in the uncertain age of Donald Trump’s global trade war — with the exception of Honda.

As rivals in Detroit issued profit warnings one after the other, Honda boosted its net profit forecast by 7.9 per cent while Toyota beat analyst expectations with record first-quarter profits. Even Subaru, with its heavy reliance on US sales, kept its annual forecast unchanged on Monday.

Japanese carmakers face the same headwinds as rivals elsewhere, including rising steel and aluminium costs due to new metals duties, changes to Chinese import tariffs and the threat of further tariffs on cars exported to the US.

But what sets them apart, analysts say, are strong sales in other Asian markets and above all, the traditional art of rigorous cost savings.

At Toyota, chief executive Akio Toyoda has pushed for a huge cost-cutting programme that draws on the group’s vaunted kaizen philosophy and relentless elimination of waste.

For the April-to-June quarter, a reduction in expenses totalling ¥65bn ($583m) helped to offset a ¥50bn hit to profits from rising raw material costs as Toyota reported a 7.2 per cent year-on-year rise in net profit.

“It’s important to create a climate where every employee has a strong awareness for costs boiling down to the use of a single pencil,” said Masayoshi Shirayanagi, Toyota’s senior managing officer.

The company’s robust first-quarter results were also driven by a 40 per cent rise in operating profits in Asia, led by strong sales in Thailand.

Honda executives also cited cost-cutting efforts as helping to absorb rising raw material costs, while the group also had rising motorcycle sales in India, Indonesia and Vietnam. Its quarterly net profit rose 18 per cent.

Analysts at CLSA and Credit Suisse projected additional rises in Honda’s guidance despite the negative impact of flooding in Mexico and the reduced vehicle sales outlook in North America and Europe.

Still, sentiment among Japanese auto executives remains somewhat chilly as they express concern about the volatile and unpredictable nature of trade discussions involving the US.

“We don’t actually know what kind of change will happen at this point,” said Joji Tagawa, corporate vice-president of Nissan, which reported a 14 per cent decline in net profit during the first quarter.“We can conduct various simulations as to what response would be effective but we can't make any decision before the US government outlines its policy,” he added.

Japanese officials will hold trade talks in Washington this week at which they hope to counter US pressure to enter bilateral trade talks and the 25 per cent tariff on imported vehicles and components being considered by the Trump administration.

Toyota, which exported 700,000 vehicles from Japan to the US last year, has estimated that the additional tariff would add up to $6,000 to the cost of each vehicle.

CLSA estimates that vehicle prices would rise on average by 13 per cent if a 25 per cent tariff was imposed, with a 9.9 per cent increase for Ford, 11.9 per cent for GM, and 16 per cent for Subaru and Nissan. In terms of financial impact, Subaru would be the most affected, with a 59 per cent projected fall in full-year operating profit, followed by a 30 per cent decline for Honda.

“It's not the case that Japanese carmakers are visibly doing better than rivals elsewhere,” said Takaki Nakanishi, a former Merrill Lynch analyst who runs his own research group.

“For the first quarter and in terms of annual guidance, the Japanese carmakers may be in the winning group. But once the tariffs are imposed, they will immediately be in the losing end.”

What Will Cause the Next Recession? A Look at the 3 Most Likely Possibilities

The expansion is nine years old. An ill-timed end of fiscal stimulus, a corporate debt bubble and the trade war are the things that could most easily end it.

By Neil Irwin

Large bubbles at a bluegrass festival in Owensboro, Ky.CreditGreg Eans/The Messenger-Inquirer, via Associated Press

The economic expansion in the United States celebrated its ninth birthday last month. If it survives another year, it will be the longest on record.

But eventually something will kill it. The question is what, and when.

While it’s impossible to predict the details or timing of the next recession with any confidence, we can identify some emerging threats to the expansion — and with a bit of imagination, picture how the recession of 2020 (or 2022, or whatever year it ends up being) may unfold.

To be clear, the economy is going gangbusters right now. The nation’s G.D.P. rose at an annual rate of 4.1 percent in the second quarter, the strongest quarter of growth since 2014. But when you speak with some of the people who fret and worry about economic risks for a living, a few factors come up repeatedly.

Perhaps most worrisome, many of the culprits in ending the expansion wouldn’t necessarily arise in isolation. Rather, each one could make the others worse, meaning the next recession might have multiple causes.

So, with a bit of creative license, here are the three most plausible scenarios for the good times to end.

The Wile E. Coyote Moment

The Federal Reserve has had a relatively easy time over the last year or two. Both inflation and employment have been gradually moving toward healthy levels as the Fed has gradually raised interest rates.

The job facing the Fed and its chairman, Jerome Powell, is on the verge of getting trickier. The risk that the Fed will miscalibrate interest rate policy and cause a slowdown or a recession is rising, in part because of the timing of the tax cuts and spending increases enacted this year.

Krishna Guha, head of global policy and central bank strategy at Evercore ISI, has a term for their likely dilemma: the “train wreck 2020” scenario.

The United States economy is either at or near full employment, and inflation is already near 2 percent. With growth still strong, Mr. Guha says, the Fed may soon find itself needing to raise interest rates more aggressively to keep inflation in check.

But at the same time, mainstream macroeconomic models have the economic lift from tax cuts fading sometime between 2020 and 2022. That means the Fed could be raising interest rates to slow the economy just as tax policy is also working to slow the economy.

Both affect the economy with unpredictable lags, so it could prove hard for the Fed to set policies that can prevent both overheating in 2019 and 2020 and a downturn in 2021 and 2022.

“There is probably some kind of perfect path where the Fed could thread the needle on this,” raising rates just enough to prevent overheating but not enough to leave rates so high as to risk a recession once the impact of tax cuts fades, Mr. Guha said. “But what’s the likelihood that you’ll thread that needle? It’s not one you’d want to be betting the farm on.”

The former Federal Reserve chairman Ben Bernanke put it more colorfully at a conference in June. The stimulative benefit of the tax cut “is going to hit the economy in a big way this year and the next year,” he said. “And then in 2020, Wile E. Coyote is going to go off the cliff.”

Pop Goes the Debt Bubble

The last two recessions started with the popping of an asset bubble. In 2001 it was dot-com stocks; in 2007 it was houses and the mortgage securities backed by them.

So it makes sense to look to various markets that might be getting bubbly in dangerous ways.

And that search leads quickly to debt markets, both in the United States and overseas.

Corporations have loaded up on debt over the last decade, spurred by low interest rates and the opportunity to increase returns for shareholders. The value of corporate bonds outstanding rose by $2.6 trillion in the United States between 2007 and 2017, according to data from the McKinsey Global Institute — rising to about 25 percent of G.D.P. from about 16 percent.

The rise in debt loads overseas, especially in emerging markets, is even greater, according to McKinsey’s data — as is a shift toward more debt being owed by riskier borrowers.

Essentially, businesses have been in a sweet spot for years, in which profits have gradually risen while interest rates have stayed low by historical measures. If either of those trends were to change, many companies with higher debt burdens might struggle to pay their bills and be at risk of bankruptcy.

The 2020 train wreck narrative could intersect with the corporate debt boom. If inflation were to get out of control and the Fed raised interest rates sharply, companies that can handle their debt payments at today’s low interest rates might become more strained. Moreover, with federal deficits on track to rise in the years ahead, the federal government’s borrowing needs could crowd out private borrowing, which would result in higher interest rates and even more challenges for indebted companies.

The International Monetary Fund included a warning about this run-up in global corporate debt in its most recent Global Financial Stability Report. If inflation were to rise more quickly, Tobias Adrian, an I.M.F. official, said in a news conference, it could “trigger a sudden tightening in financial conditions and a sharp fall in asset prices,” which is I.M.F.-speak for the kind of thing that can endanger economic growth.

Susan Lund, a partner at McKinsey, does not see the rise in debt as likely to cause some macroeconomic crisis, but said it could cause distress for individual companies.

“I think there will be a rise in defaults, but I’m not alarmed,” she said. “I don’t see systemic interlinkages.”

The 2007 housing downturn became a 2008 global financial crisis because mortgage-backed securities were stuffed throughout a highly leveraged global financial system. The 2000 dot-com crash became a 2001 recession because it triggered a broader pullback in corporate investment.

The question is whether the potential challenges for corporate borrowers in the years ahead can remain more isolated than in those precedents.

The Trade War Cometh

Many words have been devoted to the economic risks of the trade war with China and other trading partners.

It is relatively easy to identify individuals and companies with plenty to lose. But exports are only about 8 percent of total G.D.P. in a $20 trillion United States economy. The direct economic cost of the American tariffs on imports and retaliatory actions by other countries announced so far should be half a percent of total G.D.P. or less, hardly enough to raise recession alarm bells.

“Trade just isn’t that big,” said Eric Winograd, senior economist at AllianceBernstein. “I have a very hard time coming up with numbers that would be big enough to cause a recession based on the trade math alone.”

For the trade war to trigger a recession, then, it would need to escalate to a much larger scale than the limited tariffs on steel, aluminum, solar cells, washing machines and $34 billion in Chinese products currently covered.

Even if it were to expand to encompass hundreds of billions of dollars worth of imports, as President Trump has threatened, in order to cause a recession it would need to prompt a broader crisis of confidence.

Perhaps the economic damage will be higher in other countries that are more reliant on trade than the United States, causing a slowdown in the global economy that reduces demand for American products over and beyond what tariffs might cause.

A global slowdown could also cause huge losses in American stock and bond markets, as American companies’ revenues abroad could plummet. That means a hit to Americans’ wealth and more expensive capital for businesses. It could be the thing that triggers a popping of the corporate debt bubble.

For the trade war to cause a recession, it would probably need to do major damage to business confidence, and lead companies to hold back from capital investments because of uncertainty over the future of trade policy.

So a trade war alone might not directly cause a recession in the United States. But a trade war that causes a global economic slowdown, a market sell-off and an evaporation of business confidence certainly could.

What are the odds of that? In a recent report, Moody’s Analytics puts what it calls the “trade conflagration” scenario, which includes a late 2019 recession, at 10 percent likelihood.

More likely, the report argued, trade brinkmanship will continue until global financial markets weaken, leading to a deal that results in some of the most severe risks being taken off the table.

Each week seems to bring alternating signals of the risks of a trade war. In mid-July, President Trump floated threats to apply tariffs to all Chinese imports, which would drastically escalate the trade war. By late July, he was making more conciliatory gestures toward the European Union about striking a deal to lower tariffs across the board.

Regardless of the true odds of the three scenarios, this much we know: The seeds of the next downturn have almost certainly already been planted. The question is which of them will grow into a problem big enough to matter.

Neil Irwin is a senior economics correspondent for The Upshot. He previously wrote for The Washington Post and is the author of “The Alchemists: Three Central Bankers and a World on Fire.”