Why expansions die

The current US expansion is now the third-longest in the post-war period. Here’s a chart from Deutsche Bank economists comparing it against the rest:

Expansions following a severe financial crisis typically last longer than their average and grow at a shallower angle. This one is no different in both regards, and at 2 per cent annual growth it has the slowest pace of any recovery since the Depression. (Also worrying is the observation from the chart that every subsequent expansion since 1970 has grown at a slower pace than its predecessor, regardless of what caused the downturn from which it was recovering.)

Age is therefore not deterministic. But with the Fed likely to raise interest rates again on Wednesday, the Deutsche Bank note provides a useful overview of the three main reasons that prior recoveries have ended.

First up, domestic imbalances:

Sometimes recessions result from overinvestment. The housing bubble and severe overinvestment in residential structures in the mid-2000s was at the heart of the collapse into the great recession and financial crisis of 2007-09. Previously, the decade-long expansion of and overinvestment in business capital during the 1990s, which culminated in the dot-com tech bubble, was the primary cause of the business-spending led recession of 2001. During both these episodes, private investment as a share of GDP had risen to nearly 20% (Figure 8). It had risen to similar heights ahead of the recession of 1980 as well. The current expansion is still “young” in terms of real investment spending. US households and firms are underinvesting in both homes and business capital, as the housing vacancy rates continue to test new lows and as the growth of business capital services remains mired at near historic lows, helping to hold down labor productivity growth. While there may be some stress in commercial real estate and autos, these sectors are not large enough to touch off a more generalized downturn in investment spending from relatively modest levels to begin with.

Second on the list is international shocks:

Global developments have contributed to downturns in the US in the past, though typically in concert with domestic imbalances or overheating. Oil shocks caused by wars in the Middle East factored importantly into US recessions during the 1980s and early 90s. These events generally exacerbated inflation pressures that led to significant monetary tightening. The development of the tight oil market in the US has reduced the likely severity of such an event in the future. At the same time, as emerging market economies, especially China, have grown in importance in the global economy, the sensitivity of the US economy to events abroad may have increased. However, a sudden collapse of activity in China or elsewhere on a substantial scale would seem to be a relatively low probability event for the foreseeable future.

And finally, Fed tightening:

The third and most frequent (historically) cause of recessions in the US is monetary tightening by the Fed in response to an economy that is overheating with inflation beginning to run out of control. As discussed earlier, significant Fed tightening, with the real fed funds rate rising more than one percentage point above its neutral rate, has been at play ahead of almost all of the previous downturns.

The first threat, from domestic imbalances, seems distant right now. In fact a bit more investment now, especially from corporates, would be welcome.

The second threat, a global shock, is never absent and its timing is always hard to predict. It will simply require the appropriate policy response should it materialise. (The same obviously applies to the other two reasons.)

But the third threat, a Fed tightening, is a curious one to consider at the moment. The Deutsche economists write that the Fed typically tightens excessively in response to the economy overheating. Yet the Fed is currently in the midst of a tightening cycle despite an inflation rate that remains beneath the Fed’s target, as it has for most of the recovery — and which in recent months has been trending lower:

Other leading indicators are also pointing in the wrong direction.

Janet Yellen has cited the need to tighten early and gradually so that the Fed would not have to tighten all at once later. A sceptic would note that perhaps the best way to slow an overheating economy without engineering a recession is simply to not overreact by excessively tightening once such tightening is warranted. Whether tightening occurs all at once or early-and-gradually seems less material than just not tightening too much.

The same sceptic would also note that the best way to hike rates back to “normal” levels would be to first ensure that the economy is sustainably growing fast enough to produce 2 per cent annual inflation. Your sceptic might finally argue that a temporary period of above-target inflation would be a splendid idea anyways. It would help to finally answer the question of just how tight the labour market really is, given lingering doubts. More substantively it also could help to offset the hysteresis effects on the labour market and the corporate reluctance to invest.

The Fed seems to disagree with the sceptic* on the grounds that the recent growth and inflation slowdown is transitory. (*Okay fine, it’s me, I’m the sceptic.) By this logic, inflation and economic growth will rebound in the second half of the year.

As even dovish FOMC members now accept that raising rates is the default expectation for the near-term, we’ll soon find out if the Fed’s reading of the economy was right.