The current US economic expansion that began in 2009 will mark its 10-year anniversary in June. The following month, it will become the country’s longest expansion on record, according to the National Bureau of Economic Research (see Chart 1).
At present, economic data and fundamentals are still positive, suggesting a recession is not imminent. Nevertheless, it is natural to think about the next downturn – and the possible response to it.
In this issue of Ahead of the Curve, we review the possible approaches to the next crisis – from both monetary and fiscal perspectives, with a particular focus on the latter – and we highlight the challenges that may lie ahead.
The US is in a mature phase of the business cycle
Given its standing on the world stage, economic developments in the US can hardly be confined to the domestic domain. Indeed, the business cycle in the US tends to lead cycles in other countries as well as that of the global economy.
Most economic data and the accommodative policy setting suggest that an imminent recession in the US is unlikely. However, some financial market indicators (in particular, the US yield curve) suggest otherwise.
Chart 1: The five longest economic expansions in US history (from 1854 to date)
||Duration in months
|March 1991-March 2001
|February 1961-December 1969
|November 1982-July 1990
|June 1938-February 1945
|November 2001-December 2007
Source: National Bureau of Economic Research as at September 2010.
Recently, US economic data have been solid. The country’s Q1 GDP surprised to the upside, recording economic growth north of 3% on a quarterly annualised basis (this partially reflected the impact from some temporary factors, such as the inventory cycle). In addition, employment growth has been solid, with the labour market adding 2.6m jobs over the last year.
Conversely, consumer and business surveys – which are running at elevated levels – have shown some cracks in recent months. In particular, the composite Institute for Supply Management’s (ISM) index – a weighted average of the main survey that gauges activity in the manufacturing and services sectors – declined to 55.2 in April, compared to 56 in May and a cyclical high of 60.7 in September 2018.
Over the last year, the expansionary fiscal stance has undoubtedly supported the country’s economic performance. Fiscal policy has added on average 0.5pp to annualised quarterly growth since Q4 2017, according to the Hutchins Centre Fiscal Impact Measure. This effect is likely to fade over the balance of the year, notably in H2 2019, given the profile of federal fiscal measures.
However, monetary policy is likely to remain accommodative for longer, following the US Federal Reserve’s (Fed’s) dovish turn earlier this year. The Fed Fund Rate is currently running at 2.25%-2.5%, which is slightly below the central bank’s mid-point estimate of neutral (which is 2.75%). In addition, the Fed has announced plans to end its balance-sheet normalisation process in October, following a slower pace of runoffs in the coming months. This implies that the Fed’s balance sheet will stabilise at about $3.75tn at the end of September – which is higher than Fed officials’ expectations only a year ago.
In addition, recent yield-curve developments have been concerning. The US yield curve is Wall Street’s favourite harbinger of recessions, owing to its strong track record: a yield-curve inversion – that is, when short-term yields rise above longer-term ones – has preceded all recessions since the end of the second world war. At the end of March, the spread between the 10-year US Treasury yield and the three-month bill rate briefly turned slightly negative. Consequently, the New York Fed’s recession probability (12 months ahead) – which is based on that spread – spiked to almost 30%, marking a high for the current cycle (see Chart 2).
Chart 2. The probability of a recession in the next 12 months spiked to almost 30% in April
Source: New York Fed as at May 2019.
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.
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.
Monetary policy: the effective lower bound issue
There are limits to monetary policy, particularly in a world where it has become increasingly constrained by the effective lower bound (ELB) and inflation expectations have slipped to lower levels.
In the wake of the 2008 global financial crisis, monetary policy had to do all the heavy lifting. Both fiscal and monetary support measures were taken in the immediate response to the crisis. In addition, there was international coordination from institutions (central banks, notably) in major countries. However, as the recovery progressed in an excruciatingly slow fashion and government debt, as a share of GDP, surged in most countries, monetary policy became the only game in town. Central banks kept interest rates low and adopted unconventional measures such as Quantitative Easing (QE) – a quasi-fiscal policy.
In November 2008, the Fed resorted to QE for the first time, buying large amounts of Treasuries and mortgage-backed securities in an effort to exert downward pressure on long-term interest rates. More action was needed: a second round of QE followed in 2010-2011; the Fed announced Operation Twist – the purchase of long-term bonds financed by the sale of short-term paper, which aimed to increase the average maturity of the Fed’s holdings – in 2011-2012; and a third open-ended round of QE took place in 2012-2014.
On the other side of the Atlantic, the Bank of England moved to adopt QE in 2009, while the European Central Bank (ECB) was late to the party, adopting it at the end of 2014. Indeed, the ECB also resorted to other unconventional measures, becoming the first major central bank to enter the world of negative interest rates in mid-2014. In this way, it played an integral role in shaping the response to the bloc’s double-dip recession of 2008 and 2011-2012.
According to some critics, the ECB was tardy in adopting crisis-fighting policies, thereby dampening the effectiveness of such policies. But the peculiar and incomplete institutional environment in which the ECB operates implies that it would have needed political cover to implement such measures.
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.
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 (see Chart 3) and close to their lowest limit, the so-called ELB. In a world where it is possible to hold cash, the ELB is around zero or slightly negative.
Chart 3. Policy rates have collapsed across major economies
Source: Reuters Datastream, based on National Sources, as at May 2019.
In order to adopt an accommodative monetary policy stance, central banks need to set their real policy rate below the equilibrium real rate – the interest rate that keeps the economy operating on an even keel – the so-called r*. R* is unobservable, but according to most estimates, it has trended down over the last few decades. The decline can be attributed to the emergence of structural factors that increase the supply of savings and/or depress the demand for investment. They include: slower trend growth (reflecting slow labour productivity growth and a declining labour force growth rate); demographics (an aging population adversely impacts the labour force and they tend to save more); weak investment (owing to low productivity and, possibly, elevated political and economic uncertainty); and international spill-overs from higher savings globally (the hypothesis of ‘global saving glut’ suggested by former Fed Chair Ben Bernanke).
According to the Laubach-Williams (LW) model, the estimate of r* for the US is now running at about 80bps, compared to approximately 300bps before the global financial crisis. Furthermore, the estimate of the natural rate of interest for advanced economies is similar (see Chart 4).
Chart 4. The equilibrium policy rate r* has trended down across the board
Source: New York Fed as at March 2019.
So, what does this mean?
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. For instance, the Fed previously responded to the financial crisis by cutting rates by an average of 500bps during its easing cycles. But, with the Federal Funds Rate currently at 2.25%-2.5%, such a move is no longer a viable option.
Low inflation expectations can be deemed as another constraint. When inflation expectations are below 2%, it means that the floor for the real interest rate is higher than it should be. In turn, a negative feedback loop would ensue between low inflation expectations and central banks’ inability to lift them.
In addition, negative rates – currently deployed in the eurozone, Japan, Sweden, Switzerland, Denmark – have side effects. In particular, an extended period of negative rates could weigh on bank profitability, which would be especially damaging in regions where banks are the main lending channel.
At the same time, QE has probably reached its limits: although the first round of QE was successful, successive rounds (in the US and elsewhere) had a weaker impact on financial markets and the real economy, which suggests that the law of diminishing marginal returns applies to QE. Furthermore, QE has probably had adverse distributional effects, increasing wealth inequality by boosting asset prices.
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. What’s more, these options will have shortfalls too. As such, the response to the next downturn needs to come from fiscal policy.