Sat, Nov 16, 2019 - Page 9 News List

New threats are pushing the US toward economic winter

As the old rules of macroeconomic cycles no longer apply, the next US recession might not stem from the US Federal Reserve or the economy, but the White House

By Raghuram Rajan

Illustration: Constance Chou

What could trigger a recession in the US? In the past, a tightening labor market after a period of expansion served as an early warning sign. Workers would become more difficult to find, wages would start climbing, corporate profit margins would tend to shrink and firms would start raising prices. Fearing inflation, the central bank would then raise interest rates, which in turn would depress corporate investment and spur layoffs.

At this point, aggregate demand would fall as consumers, fearing for their jobs, reduced their spending. Corporate inventories would then rise and production would be cut further. Growth would slow significantly, signaling the beginning of a recession. This cycle would then be followed by a recovery. After firms worked down their inventories, they would start producing more goods again, and once inflation had abated, the central bank would cut interest rates to boost demand.

However, this description seems to apply to a bygone era. Because inflation is now persistently muted, it is no longer a reliable trigger for interest-rate hikes and the slowdowns that followed.

More recent recessions have been precipitated instead by financial excesses accumulated during the expansion: In 2001, the excess was in stock-price growth during the dot-com boom; in 2007 to 2008, it was in financial-sector leverage following the subprime mortgage boom.

While rate hikes by the US Federal Reserve preceded these recessions, they were not responses to above-target inflation, but rather attempts to normalize monetary policy before inflation actually took off. Inflation today is still below the Fed’s target and anticipatory tightening is not even on the table (for a variety of reasons).

When the Fed embarked on raising rates last year, US President Donald Trump’s administration doubled down on its trade campaign. After markets started tumbling late last year, the Fed backed off. With a comprehensive US-China trade deal nowhere in sight and with a formal impeachment inquiry into Trump underway, the Fed is unlikely to tighten monetary policy any time soon.

Trump has made it clear that he would blame the Fed in the event of a recession. Having calculated that the reputational risks of slightly higher inflation are smaller than those associated with a downturn after a rate hike, the Fed would not be inclined to raise rates for the time being.

Instead, the Fed has cut rates three times this year to “buy insurance” against a downturn. Besides, it has been emphasizing that its inflation target is “symmetric,” meaning that it would be willing to tolerate a period of above-target inflation, given that it has undershot the target in recent years, before intervening.

If higher interest rates are unlikely to be the precipitating factor in the next recession, what about financial excesses? Looking around, one can certainly see areas with high asset prices and high leverage, such as in private-equity deals.

The IMF has warned of substantial corporate financial distress if growth slows significantly; yet, it is difficult to see widespread problems materializing if interest rates stay low and liquidity remains plentiful.

Of course, at some point, growth would slow or interest rates would rise, and liquidity would tighten. Whenever that happens, financial assets would suffer significant price declines and corporations would find it difficult to roll over debt. The longer the environment of easy financing lasts, the greater the number of sectors with excesses would be, and the higher the risk that these would precipitate a downturn.

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