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Capital Economics warn next US recession only a few years away

17 August 2017

US economist Michael Pearce explains why a recession in the US might follow in 2019 despite the stimulative effect of president Donald Trump’s mooted tax cuts.

By Rob Langston,

News editor, FE Trustnet

While a recession in the US is not thought to be imminent, consultancy Capital Economics has suggested that a downturn for the world’s largest economy could occur in the next couple of years.

US economist Michael Pearce said while recessions are “notoriously difficult to predict” it has recommended clients consider the prospect of a downturn before the end of the decade.

Pearce said the current economic cycle is almost 100 months old and the third longest on record.

Source: OECD

Although the current economic cycle is long by historical standards, it does not necessarily mean that a recession is overdue, however.

“Other countries have seen much longer stretches of uninterrupted growth,” he said. “Australia has not had a recession since 1991.”

Yet, Pearce said current economic expansion does seem to have used up much of the spare capacity generated by the global financial crisis.

He said: “We expect the current economic expansion to continue for the next year or two, by which time it will be the longest on record.

“But all expansions come to an end, and the rise in interest rates we expect over the next few years will push the economy into a mild recession before the decade is out.”

The recent shift by the Federal Reserve to tighten monetary policy could provide one signal that a recession is due, according to the economist.

While a number of factors contribute to a recession, the trigger for every downturn over the past four decades has been increase in real interest rates to 2 per cent or more, said Pearce.

“Every recession in the past 40 years was preceded by a rise in real interest rates, which triggered a sharp decline in investment and durable goods consumption,” he said.


“We suspect this story will be repeated in the years ahead. Admittedly, the Fed has raised interest rates only four times so far this cycle and in real terms, rates are still negative.

“But the neutral level of rates is lower now, meaning that the 150bp of rate hikes we forecast over the next two years may well be enough to generate a recession.”

Effective federal funds rate over 10yrs

Source: Federal Reserve Bank of New York

The Fed, under current chair Janet Yellen, has become more hawkish as it prepares to exit the post-financial crisis policies that helped support the economy as the financial system faced collapse.

However, with inflation thought to be on the rise pressure to increase rates has increased.

The last US recession between 2007-2009 lasted 18 months and saw a 4.2 per cent decline in GDP, while 8.7 million jobs were lost as the global financial crisis posed one of the biggest challenges for the global economy since the 1929 Wall Street Crash.

Pearce said the average post-war US recession has tended to last around a year, with GDP shrinking by more than 2 per cent and employment dropping by 2.5 million. Yet, the economist believes any potential recession would be “mild”.

“In the absence of major imbalances or vulnerabilities, we suspect the coming recession will be on the mild end of the spectrum,” he said.

“Debt burdens have not risen markedly, house prices as a ratio of earnings or rents are in line with historical averages, and there are few signs of excess investment in the economy.

He added: “One potential vulnerability is the equity market, which appears to be overvalued on a number of metrics.

“But it would take a big fall in equity prices to deliver a meaningful hit to household wealth or confidence.”


US equity valuations have been a source of concern with the S&P 500 index trading at higher valuations and the effects of the so-called ‘Trump bump’ following last year’s presidential election continues to be felt.

One of the biggest differences from past recessions, however, is the lack of room that the Fed has to loosen policy, Pearce explained.

“If a recession hit before the Fed had a chance to rebuild its policy arsenal, there’s a significant risk that policy would end up stuck at the effective lower bound again.

“That raises the spectre of a long period of (even) weaker growth and inflation, along with an increased risk of asset price bubbles.”

The economist said if congress were to pass a deficit-financed tax cut, it would increase policymakers’ ability to boost growth and five the Fed time to raise rates.

However, even if president Donald Trump were able to pass them next year – which is not guaranteed after recent problems dismantling Obamacare – the economist said that growth would “probably begin to falter in 2019”.

“By 2019, we think the Fed will have the scope to counteract a mild recession, he explained. “In those circumstances, there is every reason to expect the damage from the next recession to be reversed fairly quickly.

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