Jul 16, 2019
Written by: Scott Hoyt, Senior Director, Moody’s Analytics
The U.S. economy is growing below its potential. Real GDP growth in the second quarter will probably come in close to 1.5%, while the economy’s current potential is estimated to be between 2.0-2.5%. If growth does not pick-up soon, job growth, which has already moderated significantly from this time last year, will throttle back further and unemployment will begin to increase.
Behind the growth slowdown is fading fiscal stimulus – the boost provided by last year’s deficit-financed tax cuts have largely played out. More importantly, the trade war with China and a long list of other trading partners have undermined business sentiment, is weighing on business investment decisions, and has even begun to impact hiring.
The current economic expansion, while the longest in history – it bested the 10-year economic expansion of the 1990s this month – is fragile. Once unemployment begins to increase, even if very low, recession risks quickly increase. Consumers sense the softening job market and turn a bit cautious in their spending. Businesses respond by pulling-back more on their hiring and some may even layoff workers. The virtuous cycle that characterizes an expansion devolves into the vicious cycle of recession.
Indeed, the most prescient indicator that an economy is already in recession is when the unemployment rate increases by more than a quarter percentage point in a three-month period. Each of the ten recessions since World War II has begun with such an increase in unemployment.
The expansion is thus vulnerable if anything goes wrong and forestalls a quick pick-up in growth back to near the economy’s potential. And there is plenty that could go wrong. Most obvious is the trade war. President Trump and Chinese President Xi called a truce in the war last month, but since then there has been no apparent progress in coming to an agreement. This is not sustainable. Either they come to some face-saving arrangement in coming weeks or another escalation in the war seems very possible.
A trade war would be a particular threat to U.S. consumers. Any new tariffs on Chinese imports would materially increase prices on many consumer goods. Retaliatory tariffs would threaten job growth. With stock valuations high, the battle could undermine financial markets and household wealth. Still-high consumer confidence would be undermined. Consumers would suffer.
The coming budget battles in Washington D.C. could also go awry. President Trump and Congress must agree to 3 pieces of budget legislation before the end of this year or risk further undermining sentiment and growth. First is the budget for the fiscal year 2020, which must be passed by the end of September or the government will shut down on October 1st. After the debilitating shutdown at the start of this year, another shutdown so soon could be too much to bear.
Next is the Treasury debt limit. Based on expected tax receipts, which have been coming in a bit soft as of late, and when bills are coming due, the Treasury will run out of cash by October 3rd. If the Treasury fails to pay someone on time, the ramifications for financial markets and the economy would be overwhelming. Investors are pricing in the possibility, as interest rates on short-term Treasury securities that mature after the drop-dead date are rising.
Then there is spending legislation that is needed by the end of the year to avoid severe cuts to government outlays, as long-dormant sequester rules will kick-in at the start of next year. The large spending cuts created by sequestration would be a substantial hit to economic growth.
Given the fast-approaching presidential election, it would seem a slam dunk that the President and Congress would come to terms and pass the needed legislation in a timely way. However, nothing is for sure, given the current politics in D.C.
Also on the list of things that could go wrong is a range of geopolitical threats. There is Brexit, which the British must decide on by the end of October. The slow-moving collapse of the Iranian nuclear deal is another significant worry. A resulting spike in oil prices would hurt the fragile U.S. economy.
All this uncertainty threatening an already soft and vulnerable economy is too much to bear for the Federal Reserve. Fed Chairman Powell has all but said that the FOMC will cut interest rates when it meets again at the end of July. It is an insurance rate cut, just in case something goes off the rails, and to ensure that the economy’s growth quickly rebounds to potential and forestalls an increase in unemployment.
Likely further motivating the Fed’s insurance cut is the view that the current funds rate of 2.5% does not give policymakers much room to maneuver if the economy were to suffer a recession. In a typical downturn, the Fed lowers rates by approximately five percentage points. The slide in long-term interest rates and the inversion of the Treasury yield curve may be another justification for an insurance cut.
The debate over monetary policy has thus shifted to how much the Fed will cut – a quarter or half a percentage point – and whether it will cut again later this year or even next. Investors are pricing in big cuts, putting greater than even odds on a funds rate that is a full percentage point lower by this time next year. The expectation that there is much more rate cutting to come has buoyed the stock market, which is posting new record highs, and eased financial conditions more broadly.
Moody’s Analytics expectation is that the Fed will cut the funds rate by 25 basis points later this month and provide investors assurance that more cuts will be forthcoming if warranted, but in the end, hold monetary policy unchanged through next year’s presidential election. Financial markets will at some point need to adjust to the reality of only one rate cut – stock prices will come under pressure, long-term bond yields will rise, and the value of the U.S. dollar will remain strong – but growth will have revived by then and the economy no longer in such a fragile place. Of course, all of this assumes everything from the trade war to the coming budget battles to Brexit and other geopolitical developments stick to script. Admittedly, a big assumption.
Scott Hoyt is senior director for Moody’s Analytics, responsible for the firm’s consumer forecasts and analysis. Dr. Hoyt contributes to Economy.com, speaks at conferences, and oversees the production of the U.S. economic forecast. He has done custom modeling for credit and consumer sector clients. His projects include estimating market size geographically for several large retail clients, analysis of spending by demographic groups and implications for the spending outlook, credit portfolio modeling, and delinquency and loss modeling. His areas of expertise include consumer spending, retail sales and industry performance, consumer credit, household income, demographics, and other aspects of consumer behavior and its macroeconomic and industry implications. Before joining Moody’s Analytics, Dr. Hoyt spent five years as an economist for J.C. Penney, where he did extensive work supporting the company’s strategic planning efforts, real estate research department, merchandise departments, and credit department. He received his PhD and MA in economics from the University of Pennsylvania and his BA summa cum laude from Bates College.