Three ways the economic and financial cycle could end

The global economic recovery that started amid the gloom of the financial crash in March 2009 is about to celebrate its 8th birthday. In the advanced economies (AEs), the GDP growth rate during this recovery has averaged only 1.8 per cent, well below normal, but unemployment has dropped from 8.1 per cent to a still fairly high 6.1 per cent. According to JP Morgan, the volatility of GDP growth has fallen to the lowest levels for four decades since 2014.

This slow but extremely steady period of expansion has of course been accompanied by much lower interest rates, which have proven terrific for asset prices. The index of total equity returns in the AEs has tripled since the bear market ended.

Janet Yellen and other officials at the Federal Reserve have said on many occasions that “recoveries don’t just die of old age”. Unless something goes wrong, the upswing in the cycle will be prone to continue. At present, econometric models that attempt to assess recession risks suggest that these risks are exceptionally low over the next 12 months.

Furthermore, the growth rate in the US and other AEs seems, if anything, to be breaking upwards. This may be because the headwinds that have held growth down for so long – excessive debt, a malfunctioning banking system, extreme risk aversion, low capital investment etc. – may finally be fading away. Perhaps the world economy is at last attaining escape velocity.

However, good times cannot last forever. It is common for euphoria to set in just when the economic and financial cycle is nearing a peak. As in 2001 and 2008, the end could come much sooner than anyone predicts [1].

So how could an unexpected recession happen? There are many ways in which this cycle could end, of which three need to be particularly watched over the next couple of years. These endings correspond to the main theories that describe the condition of the developed world at present [2] :

  • demand side secular stagnation (associated with the ideas of Lawrence Summers);
  • positive demand shocks combined with supply side weakness, leading to inflation pressure (associated with concerns expressed by Janet Yellen about the risk of raising US interest rates too slowly); and
  • a downturn in the financial super cycle (associated with the thinking of Claudio Borio at the BIS).

Demand side secular stagnation is by now very familiar. This school believes that there has been a shortage of demand for many years, even decades, stemming from some of the headwinds listed earlier.

Adherents believe that there is a high probability of recession in the next two or three years. Although the exact mechanism is not spelled out, it would be connected to a slump in final demand that cannot be corrected by monetary policy, because interest rates would return to the zero lower bound. Meanwhile, fiscal policy might be too slow to react, or might be hamstrung by high public debt ratios.

One possible cause of this downward shock to global demand would be a trade war, which appears more threatening after the ambiguous G20 statement this weekend.

These demand side issues seriously concerned investors a year ago, when recession risks temporarily surged. But the robust activity data in recent months suggest that the danger of a recession occurring because of a negative shock to final demand has now receded sharply.

A different end to the cycle could occur if it turns out that inflation is not as subdued as most economists, and the major central banks, are assuming. In previous cycles, unexpected rises in inflation have sometimes happened because of a major upside shock to oil prices, stemming from conflicts in the Middle East or supply restrictions by OPEC. But the fundamental balance of supply and demand in the global oil market does not seem likely to take oil prices back towards previous peaks in the near future.

If inflation rises, it will more likely be because strong growth in global demand is maintained, while the supply side in the AEs fails to respond. Assuming productivity growth remains extremely subdued, then the current rate of growth is unlikely to be compatible with stable inflation for very long. That is certainly the case in the economies that are most advanced in their recoveries, like the US and the UK.

The Federal Reserve, surprisingly, made no reference to upside risks to US growth last week. This seems at odds with the evidence that we are getting from our US nowcasts, which show US activity expanding at a rate above 4 per cent, double the Fed’s forecast for 2017 growth. The FOMC is trying to tighten policy, but interest rates are still 200 basis points below the level recommended by a standard Taylor Rule, without even taking account of the stimulative impact of the Fed’s bloated balance sheet on the monetary stance. The Fed may be behind the curve.

As Jeffrey Lacker, President of the Richmond Fed, warned recently, it is possible that inflation could rise rather suddenly, as it did in the mid 1960s, in which case the FOMC would be forced to slow the economy precipitously, even risking a recession. In fact, that would be the “standard” way for the cycle to end, and it is becoming somewhat more probable. Given the likely sharp rise in US interest rates and the dollar, this ending would be likely to have very adverse consequences for the emerging economies.

The third type of ending could occur if there is an implosion in the global financial cycle, leading to a period of deleveraging and rising risk aversion in markets. The idea here is that there is a long term cycle in financial markets that may operate independently from the business cycle in the real economy.

Claudio Borio, the main proponent of this view, suggests that the expansion phase of this financial cycle may now be rather advanced in the US, and he has for a while been concerned about extended credit cycles in China and many other emerging economies. An implosion in any of these credit cycles could take the US and global economy down with them, especially in the context of unfinished repairs to bank balance sheets.

However, while Borio’s warnings about financial excess deserve to be taken extremely seriously, international financial regulators are finding it hard to discern near term signals of extreme financial dislocations in the US or the emerging markets at the present time.

What conclusions can we reach? The table below shows some subjective conclusions that have emerged from much debate within the Fulcrum economics department. We assign a low risk of only 10 per cent to an end to the US economic and financial cycle within 12 months. (For comparison, our statistical recession probability model is at 0-5 per cent, while the Survey of Professional Forecasters suggests 17 per cent.)

The probability of an end to the cycle occurring within 24 months is much higher, at 30 per cent. Over that length of time, the current strength of activity indicators is less relevant to the calculation, and the frequency of cyclical downturns in long term historic data needs to be recognized. [3]

As to the possible nature of the cyclical downturn, we currently assign a higher probability to a hostile Fed, because of rising inflation risk, than to either of the other two stories. This has implications for the possible behaviour of equities and bonds during any downturn – and of course for the appropriate policies that might extend the cycle beyond two years.

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Footnotes

[1] For simplicity, this deliberately blurs the distinction between economic and financial downturns, though their timing is usually linked.

[2] These theories refer mainly to the advanced economies, and particularly the US where the cycle appears to be more progressed than in other countries. The three identified endings would certainly interact with each other, and are therefore not entirely independent. However, each of them represents a distinct diagnosis of the main ailments that could result in an abrupt end in the current economic and financial cycle.

[3] The 30 per cent risk of an end to the cycle within 24 months is the same as that implied in the latest SPF forecasts. However, to demonstrate the subjective nature of these estimates, Lawrence Summers suggested in November 2015 that there was a 63 per cent probability of a US recession occurring within 3 years from that date. I do not know of any sensible way to avoid subjectivity and judgment in making these important estimates.

This post originally appeared on Financial Times

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