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So what does that mean for the economy moving forward?

Apr 2019
Julianna Donovan

Spring forward, Fall back.

You can set your clock to daylight savings, however, in the case of the economy patterns vary over time. Last spring, economic growth was accelerating to an annualized rate of 4.2% in the second quarter, fueled by tax reform and robust consumer spending. But that pace has proved unsustainable as fiscal stimulus (tax cuts and government spending) “pulled forward” some amount of demand from subsequent quarters such that by the end of last year growth slowed to 2.2% (roughly half the annualized rate in the second quarter as shown in the accompanying chart). The Federal Reserve Board, which sets interest rate policy to keep the economy from either stalling or overheating, recognized the slowdown and revised its approach to monetary policy and expectations for growth.

The Fed raised interest rates to 2.5% last December and predicted more increases to follow in 2019. At the Fed’s most recent meeting in March, it made no change to interest rates. It took the further step of revising its prior projections to remove any predicted increases for this year. We now believe the Fed has reached the “peak” of the interest rate cycle after raising rates nine times in three years. Some investors are already predicting a rate cut this year, signaling a belief that the economy will weaken further. We see slowing economic momentum in the U.S. and believe growth is unlikely to reaccelerate as the impact of expansionary fiscal policy diminishes in 2019. However, we do not think the economy will slow significantly more to warrant a cut in interest rates.

So what does that mean for the economy moving forward?

As we have noted many times, the current expansion is among the longest ever, approaching eleven years in length. As growth slows and time passes, it is natural to conclude the next recession might be imminent. Our view is that is not the case. While there are always risks to our forecast, we expect growth to continue at the moderate rate of about 2% for the rest of this year and likely into next year as well. Here are the factors that form the basis for our view:

Compared to previous cycles, large imbalances in the financial sector or markets have not built up to the point where they pose a risk to the real economy.

Past recessions have been precipitated by excessive valuations in assets such as stocks in 2000 or real estate in 2007, combined with overly accommodative (low) interest rates followed by the Fed tightening monetary policy. This dynamic led to excessive debt levels at prior cycle peaks that had to be written down as asset prices declined and defaults increased. While Government debt is historically high, household and corporate debt levels are vastly improved. Both in terms of the nominal amount of debt outstanding and the interest carrying costs.

In some cases, the Fed has contributed to prior recessions by raising rates aggressively in an attempt to correct large imbalances.

In the current cycle, the Fed has room to move slowly and adopt a “wait and see” approach. This is exactly what we predicted.

Inflation for commodities, goods and services, and wages remains low.

While oil prices have rebounded from a sharp sell-off last year, the current price of $61 per barrel is far below the 2014 peak of $105. This is positive for sectors of the economy with large energy inputs such as industrials and manufacturing, as well as for consumer spending.

Consumer spending is healthy, which is important as it accounts for about two-thirds of economic output.

Household net worth has recovered from a low of $58 Trillion in 2009 to $109 Trillion today. Thanks to low-interest rates, debt service payments as a percentage of disposable income have fallen from 13.2% to 9.9%. This is the lowest level in more than forty years.

The labor market is strong.

Robust job creation along with decent wage growth has supported consumer spending, and new claims for unemployment are relatively low. The unemployment rate is very low at 3.8% down from 10% in October of 2009.

As always, there are potential risks:

Interest Rates and Inflation.

Rates are too low if inflation picks up, which may happen given the tight labor market. On one hand, if interest rates need to be raised quickly the housing market and consumer spending are put at risk given how low mortgage and lending rates are today. On the other hand, if rates need to be lowered that would have a stimulative effect but would also be in response to greater economic troubles.

Tariffs and Trade.

Negotiations with China are taking place and we continue to believe some compromise eventually will be reached.  This is ultimately in the best interest of both countries.

Slowing Growth Outside the U.S.

We observe growth slowing especially in the Eurozone mostly on account of slowing global trade and political uncertainty in the U.K. and Italy weighing on business confidence. We view this risk as relatively contained for now, but that may change over time.

The U.S. Dollar.

The dollar is trading roughly at the mid-point of its long-term historical range. If the dollar were to appreciate relative to the currencies of major trading partners, it would negatively affect the earnings of U.S. companies in overseas markets. It could result in a decline in exports, dragging down overall economic growth.

In Summary:

  • We expect the current moderate expansion to continue as interest rates remain stable.
  • Potential risks appear relatively contained.
  • We see no sign of imbalances large enough to warrant correction through tighter monetary policy.
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