The US economic expansion will reach its 10-year anniversary this month but – although there are few signs of an imminent recession – there are some questions over how the next downturn could be handled.
As the table below shows, if the US economy continues to grow in July it will be the country’s longest expansion on record. Given its position on the world stage, the health of the US is essential for the global economy and signs that it could be entering the latter part of the cycle have led some to start thinking about how authorities around the world will cope when conditions start to sour.
Hermes Investment Management senior economist Silvia Dall’Angelo noted that most economic data and the accommodative policy stance of the Federal Reserve suggest it is “unlikely” that the US will suffer an imminent recession.
She described recent US economic data as “solid”. GDP surprised to the upside in the first quarter of 2019, growing more than 3 per cent on a quarterly annualised basis, while around 2.6 million jobs have been created over the past year.
The five longest economic expansions in US history (from 1854 to date)
Source: Hermes, National Bureau of Economic Research as at Sep 2010
However, the economist also pointed out that “some cracks” have started to appear in consumer and business survey data while there has been a slight yield-curve inversion, which has traditionally been an indicator of recession.
“Former Fed chair Janet Yellen has often said that ‘expansions do not die of old age’. But the current expansion looks increasingly tired and fragile. The US economy is showing signs of late-cycle dynamics and the US yield curve is flashing amber,” she added.
“Furthermore, the longer the current accommodative setting for monetary policy lasts, the easier it is for financial imbalances to build up. In turn, this implies that the financial system is more vulnerable to even small shocks. And there is another crucial point we must consider: trade tensions between the US and China are ongoing and a further escalation involving more countries would likely lead to a recession.”
When the global economy was hit by recession in the wake of the 2008 financial crisis, it was the world’s central banks that stepped in and used ultra-loose monetary policy – in the form of historically low interest rates and quantitative easing programmes – to do “all the heavy lifting”.
This effort was subject to a degree of international coordination, with the Federal Reserve, Bank of England, Bank of Japan, European Central Bank and others maintaining a very accommodative stance.
Dall’Angelo believes that monetary policy is at the limit of what it can do. “Today, we are navigating the late-expansion stage of the business cycle – and monetary policy space is extremely constrained. Worryingly, central banks have little ammunition to respond to the next downturn,” she said.
“For a start, nominal policy rates globally have been trending downwards in recent decades; they are now running at levels that are low by historical standards and close to their lowest limit, the so-called ELB [effective lower bound]. In a world where it is possible to hold cash, the ELB is around zero or slightly negative.”
The equilibrium policy rate r* has trended down across the board
Source: Hermes, New York Fed as at March 2019
When central banks are setting an accommodative monetary policy stance, the Hermes senior economist noted, they need to set their real policy rate below the equilibrium real rate (or, the interest rate that keeps the economy operating on an even keel).
While this so-called r* is unobservable, most estimates suggest it has trended down over recent decades thanks to factors such as an ageing population, slower trend growth, weak investment and spill-overs from higher savings globally.
The Laubach-Williams (LW) model’ estimate of r* for the US is now running at about 80 basis points, compared to approximately 300 basis points before the global financial crisis. Indeed, as the chart above shows, the estimate of the natural rate of interest for advanced economies is similar.
“Essentially, during the next recession, central banks will be unable to provide the same amount of stimulus that they deployed during previous crises. They will not be able to move the real policy rate significantly below a low r* by cutting nominal interest rates – and they will hit the ELB more often,” Dall’Angelo explained.
“For instance, the Fed previously responded to the financial crisis by cutting rates by an average of 500 basis points during its easing cycles. But, with the Federal Funds Rate currently at 2.25-2.5 per cent, such a move is no longer a viable option.”
Furthermore, the economist argued that quantitative easing has probably reached the limit of what it can do to stave off a downturn. While the first round of QE was successful, the bouts that followed in the US and elsewhere appeared to show diminishing marginal returns.
“In other words, major central banks only have limited options available to respond to the next crisis – that’s despite reassurances that their toolboxes are still plentiful,” she said. “What’s more, these options will have shortfalls too. As such, the response to the next downturn needs to come from fiscal policy.”
Orthodox economic theories tend to be wary about the merits of fiscal policy as the high public debt that comes with using it to ease a downturn tends to carry high costs, in both fiscal and welfare terms.
But Dall’Angelo noted that the tone of the intellectual debate around fiscal stimulus has started to change of late. Following an intense focus on monetary policy, more attention is being paid to the potential benefits of larger fiscal deficits, with those from both orthodox and heterodox schools of economic thought advocating a bolder fiscal policy response.
“At the most extreme, the heterodox Modern Monetary Theory [MMT] has gained prominence: it has become popular among some politicians, receiving attention from investors and the media,” she said.
“According to MMT proponents, as long as a government has control of its currency, the only effective constraint to fiscal spending is inflation. In a context of low inflation, governments can simply print money to finance public spending. In our view, there are risks to adopting an MMT approach. It could potentially result in the debasing of fiat currency and, in turn, hyperinflation.”
That said, some prominent members of more orthodox schools of thought seem to be more open to higher fiscal deficits with former International Monetary Fund chief economist Olivier Blanchard recently fiscal and welfare costs of high public debt are low in current circumstances.
Meanwhile, noted economist Larry Summers has championed a more active role of fiscal policy and criticised the fiscal austerity that followed the crisis, while distancing himself from MMT.
However, Dall’Angelo highlighted that public debt levels are already high across most countries, creating a significant problem for higher fiscal deficits. The Bank for International Settlements estimates that public debt as a percentage of GDP averaged 98 per cent in the third quarter of 2018, suggesting there is limited room for more fiscal expansion.
Furthermore, few countries have been able to successfully coordinate monetary and fiscal policies to run high public debt levels while keeping inflation in check, with Japan being one of the handful of examples of this being carried out.
Should the market become concerned by the level of debt building up in a country, investors will demand higher compensation to hold debt and this can eventually compromise the sustainability of the debt itself, damaging the economy.
But these aren’t the only reasons why the policy responses to the next downturn are limited. Alas, monetary and fiscal policies face other challenges.
“To be effective during a financial crisis, international coordination is necessary. Indeed, in the aftermath of the Lehman Brothers collapse, there was a coordinated international policy response,” Dall’Angelo concluded.
“Today, some global challenges, such as tackling climate change, also call for coordinated policy efforts. But in an increasingly fragmented international landscape where the fortunes of multilateralism are falling, it is unclear whether the response to current and future global challenges and crises will be effective.”