Slower growth prompted by the withdrawal of stimulus and raising of interest rates could leave the US economy at risk of recession by 2020, according to consultancy Capital Economics.
After a decade of accommodative monetary policy following the global financial crisis, central banks around the world have started to withdraw stimulus with economies now on surer footing.
This ‘normalisation’ of policy has been led by the US Federal Reserve, which was the first of the major central banks to begin raising rates.
The Federal Open Markets Committee (FOMC) has already raised the federal funds rate twice this year and is expected to raise the rates further in the coming months and years.
FOMC participants’ assessments of appropriate monetary policy – ‘Fed Dot Plot’
Source: Federal Reserve
Further gradual increases in the target range for the federal funds rate “will be consistent with sustained expansion of economic activity, strong labour market conditions, and inflation near the committee's symmetric 2 per cent objective over the medium term,” the central bank noted in June.
However, analysts at Capital Economics claimed that while rates remain relatively low in terms of absolute levels, “the cumulative increase has been substantial”.
“It is already comparable to the increase in rates that preceded each of the last three downturns,” they noted.
“We expect that monetary tightening to weigh more heavily on rate-sensitive spending next year; including durable consumption, business investment, housing and inventories.”
Conditions in the labour market are also likely to support further rate hikes by the Fed, with unemployment rates heading below 4 per cent.
Another indicator supportive of further rate hikes is inflation, which has begun to head towards the Fed’s 2 per cent target more recently.
“Core inflation has rebounded sharply in recent months, confirming that last year’s decline was due to transitory factors,” the consultancy said. “We expect core inflation to edge gradually higher over the next 12 months.”
As such, Capital Economics expects the FOMC to raise rates once per quarter over the next year, which could push borrowing costs facing households and businesses higher.
Increased pressure on borrowers could then lead to a potential recession should a potential drop-off in growth emerge.
Indeed, the withdrawal of quantitative easing stimulus – quantitative tightening – could have a significant impact on the economy having driven the post-crisis recovery over the past decade.
“The Fed is likely to continue gradually shrinking its balance sheet as planned over the next 18 months,” the consultancy’s analysts said.
“Over the first eight months of its normalisation, the Fed reduced its holdings by only $100bn but the plan is to step up the pace of the run-down gradually.”
While Capital Economics expects economic growth to reach 2.9 per cent this year, the consultancy warned that growth could slow to around 2 per cent in 2019, before falling to 1.3 per cent in 2020.
“In that environment, we expect the Fed funds rate to peak at just below 3 per cent in mid-2019, with the Fed being forced to cut interest rates again in 2020,” the analysts noted.
“There would clearly be a significant risk of a recession occurring in 2020, particularly if current trade tensions spiral out of control.”
Source: International Monetary Fund
It should be noted, however, that the growth forecasts are lower than the International Monetary Fund, which expects the US to grow by 2.5 per cent in 2019 as the impact of US tax reform filters through to the economy.
This year the economy has been supported by a pick-up in consumption growth and this could remain a key driver of the economy later in the years as real disposable incomes have been boosted by US president Donald Trump’s tax reforms, a rise in employment levels and a gradual increase in hourly wage growth.
“The economy has also benefited from an acceleration in export growth, although that may not last much longer,” Capital Economics said. “That acceleration reflected the dollar’s decline and the synchronised strength of global demand, which now appears to be fading.”
The move towards greater protectionism is likely to be a considerable factor in any potential economic downturn, although the impact so far has been minimal, according to Capital Economics.
“The protectionist measures actually put in place so far – rather than just threatened – will not have any significant impact on either GDP growth or domestic inflation,” the analysts said.
“But tariffs on all US-China trade, the demise of NAFTA [North American Free Trade Agreement] and/or the imposition of motor vehicle tariffs would all have a more marked impact.”
Trump imposed tariffs for steel and aluminium imports from the EU, Canada and Mexico for ‘national security’ reasons in June, prompting furious reactions.
Canada retaliated with like-for-like tariffs, while Mexico additionally levied tariffs on bourbon, pork, cheese and apples.
As well as reciprocal tariffs, the EU also opted to impose charges on culturally-significant products such as cranberry and orange juice, peanut butter and motorcycles.
The retaliatory measures prompted iconic motorcycle manufacturer Harley-Davidson to announce that it would shift some production outside of the US.
So far, the US and China remain locked-in trade talks, however, some commentators have suggested that a trade dispute would have a more significant impact on the US rather than China.
Should the burgeoning trade dispute escalate into a full-blown trade war, Capital Economics believes the impact on growth could prompt the Fed to halt its rate-hiking programme in the latter half of 2019 before cutting rates in 2020.
Source: St Louis Federal Reserve
And it could also see the Fed suspend balance sheet normalisation, with the central bank’s total assets now standing at around $4.5trn after ballooning in the wake of the financial crisis.