Anxious About the Economy? It'll Still Set a Record
The current U.S. economic expansion is one of the longest on record. The longer it lasts, the more likely growth will become tepid and uneven, raising angst about its sustainability. See the May employment report, with its disappointing 138,000 gain in payrolls, downward revisions to previous months, and soft wage growth. Yet, at the same time, the unemployment rate fell to the lowest level since 2001. Anxiety is elevated with speculation that the Trump administration's pro-growth, fiscal stimulus plans are on the ropes.
Don't be nervous. It might be a bit early to make this call, but I will make it anyway: I have trouble putting anything more than trivial odds on a recession in 2018, or even 2019. At this point, the best bet is that this expansion, which started in 2009, at least ties -- if not beats -- the current record of 10 years.
One important point to remember when evaluating recession calls is that the economy is far more resilient to negative shocks than bears like to believe. Consider that the economy survived the 1987 Stock Market Crash, the 1997 Asian Financial Crisis, the European Financial Crisis of 2011/2012, and -- possibly most important because of its domestic origin –- the 2015 Shale Oil Bust, without teetering into recession.
Also consider that assuming the Federal Reserve raises interest rates next week, there will have been four hikes totaling 1 percentage point in the rearview mirror, policy makers would have room to cut rates to offset negative shocks. That is enough room, for example, to match the Fed’s response to the Asian Financial Crisis.
The economy, however, has not proved resilient to excessive monetary action. Far more often than not, tightening cycles end in recession. This is where the yield curve comes into play as a recession predictor. During a tightening cycle, the impact of higher rates at the short end of the yield curve typically outweighs that at the long end. An inversion of the yield curve signals the tightening has become excessive, threatening economic growth. Generally, longer-term yields fall further, deepening the inversion, as market participants expect the Fed will soon begin cutting short-term rates.
Recent history suggests that the greatest risk of recession occurs if the Fed continues to tighten after the initial inversion of the yield curve, which happened prior to the last two recessions. The Fed’s rapid policy reversal in 1995 prevented the tightening cycle from evolving into a recession. How much tightening remains before the Fed inverts the yield curve? The central bank's “dot plot” projections indicate that policy makers anticipate another 1.25 percentage points by the end of 2018, raising the possibility of an inverted the yield curve. Some policy makers anticipate even more. Case closed for a 2018 recession, right?
No. First, this assumes that longer-term yields do not respond to tightening at the short end. But if longer-terms rates are rising, then the Fed has more room to maneuver. Second, the Fed’s projections are just a forecast, not a promise. My assumption is that the economic conditions most likely to contain long-term rates -- weak growth and inflation -- would more likely than not prevent the Fed from meeting its current forecast. Sure, there are hawks at the Fed, but the doves have won the day more often then not during this expansion. Third, the Fed could pull a repeat of 1995 and reverse course at the first hint of they were off course, thus sustaining the recovery.
Finally, there is a delay between yield curve inversions and recessions that makes a downturn in 2018 very unlikely. Prior to the past two cycles, the yield curve inverted more than a year before the subsequent recession.
So, even in the scenario where the Fed sticks to its current projections through 2018, the yield curve inverts at the end of 2018, and the Fed does not reverse course in 2019, the earliest one might expect a recession is late 2019 or early 2020.
The current expansion began in June 2009. If it holds until June of 2019, it will match the previous record. By my reckoning, the economy will very likely make it to that point and beyond. To prevent that outcome, the Fed needs to step on the brakes hard within the next 12 months. Given the recent inflation numbers and, now, the choppy employment and weak wage data, doubts are growing that they will even meet their current rate projections, let alone exceed them.
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