By most measures, employment is as strong as it has ever been. For example, initial unemployment claims as a percentage of the labor force are by far the lowest since records started. The May 2018 unemployment rate dropped to 3.8%, a level touched only once since 1969 – on April 2000, just as the stock market peaked before a 30-month-long bear market and the economy fell into a recession.
Strong economic indicators are always welcome, but they do not guarantee that growth can be sustained. Take retail sales, for example: they are now at a record high, but they were also at record highs just before the two previous recessions. How can this be?
Forecasting the economy is just as difficult as forecasting the stock market. Economists are very good at explaining what already happened and why, but not so at predicting what will happen next.
They know this. Prakash Loungani, an economist at the IMF, showed in a study that professional forecasters missed 148 out of 153 world recessions. This is not surprising: Economic indicators very rarely flash any warnings before a recession actually arrives. Economic downturns seem to come unexpectedly.
Regardless of the difficulties, analysts are always looking for clues. One measure that has received attention as a predictor of future recessions is the shape of the yield curve. It seems that when longer-term rates drop below short-term rates, a recession often follows. But this is also true for unemployment claims: a recession seems to follow whenever they drop below 300,000.
This is a difficult set of facts to rationalize. On one hand, it is easy to speculate that when longer-maturity rates drop below shorter rates it is because the market expects future economic activity to weaken. On the other hand, explaining why strong levels of employment precede a recession is not easy, even though it is also appears to be true.
While the yield curve today is not yet at levels associated in the past with approaching recessions, this may be due to technical reasons that could have moved the threshold upwards, such as negative rates still widespread elsewhere. But unemployment levels are well beyond recession-preceding thresholds, and in any case both indicators are moving in a direction that should cause concern.
Still, it is not obvious why economic indicators often show their best performance before the economy takes a turn for the worse. One explanation could be that it is difficult to rein in distortions when the economy is firing on all cylinders.
Sometimes this is due to politics. When the economy is sluggish, policymakers in charge are accused of ineptitude or lack of concern. To prevent this, they tend to stimulate growth regardless of consequences, and the strategy eventually backfires.
Other times, imbalances happen without blunt policy interventions, such as when asset values take off and build a bubble. Policymakers are leery of taking the punchbowl away when everybody seems to be getting rich, even though that is precisely what they should be doing. But bad policy is often good politics.
Are there any such dangers lurking in the US economy today?
To many, stock market valuations appear overstretched. In addition, the combination of a huge tax cut, a spending increase and an aggressive trade stance adopted by the Trump administration, while intended to keep the expansion going, may not end up well.
The Fed could raise rates too quickly, for instance, if it thinks that the economy is running the risk of overheating or inflation pressures start to mount. Given the enormous amount of private debt built up after years of rock-bottom rates, this could drive some debtors to insolvency and trigger a broad crisis.
Another scenario would be that lower taxes and higher spending cause public debt levels and budget deficits to explode, forcing a drastic reversal of policy that could choke growth. This is not idle speculation. Virtually nobody that has looked carefully at the details of current fiscal policy, among them the Congressional Budget Office, the Tax Policy Center and the Joint Committee on Taxation, believes that the current largesse could create enough growth and pay for itself.
The U.S. expansion may be close to its end just because of old age, given that it has lasted almost nine years and is now the second longest in U.S. history. While economic indicators are strong, they were also strong just before past recessions. And anyone who thinks that a recession is unlikely should keep in mind that it also seemed unlikely to professionals trained to predict recessions 148 out of the last 153 times.
Questions? Reach me at raul@pathfinancial.net.
