Is the US headed for a recession?

Published on 07 Jun, 2019

Boom and bust are integral to an economic cycle. An upturn is marked by optimism, reflected in increase in consumption. This gives a boost to investment and consumer spending, which then rises to the point of becoming excessive. It is then corrected by the ensuing recession or bust. Historically, it has been observed that the longer the boom period, the more severe the recession.

The US economy’s expansion cycle, which began in June 2009, is on the verge of completing a decade, the longest in the country’s history. The current expansion is twice as long as the average post-WWII growth of about 58.4 months. The common thread running across all the previous 11 recessions after the Second World War is that they were preceded by Fed rate hikes, wherein a drop in unemployment was witnessed in every instance prior to the recession.

In December 2018, the Federal Reserve raised its benchmark interest rate by a quarter-point. The Central Bank increased the target range for its benchmark funds rate to 2.25–2.5%. This was the fourth hike in 2018 and the ninth since it began normalizing rates in December 2015. Although the Fed announced in a separate statement that it was prepared to slow or even reverse the steady slimming of its bond portfolio to boost the economy, markets reacted negatively and plunged for the next few days. Yields on low-grade corporate debt also jumped. Toward the end of 2018, economists at JPMorgan Chase indicated a 65% probability of a recession in 2019. Aggravating fears, consumer spending tanked, while one of the most reliable indicators of recession, the yield curve, inverted (long-term debt yield is lower than short-term debt yield) for the first time since mid-2007.

To allay fears, the Federal Reserve announced that it would not raise interest rates in 2019. Furthermore, the economy’s strong growth momentum continued, while unemployment decreased. Low interest rates, coupled with an improvement in labor market, instilled confidence. Also, major economic predictors showing an increased threat of a recession scaled back. This led to renewed optimism which culminated in stock market bounce back.

This is not to imply that the possibility of a recession has dissipated completely. There hangs an air of uncertainty and pessimism. The skepticism could turn into a self-fulfilling prophecy—Richmond Federal Reserve President Tom Barkin put it succinctly, “We could talk ourselves into a recession”. Barkin explained that market sentiment could fluctuate as the continued recovery, soon expected to become the longest on record, and constant dissemination of economic news by smartphones turn businesses and consumers jittery.

The escalating US–China trade war has fueled fears further. In May 2019, the US upped the ante by imposing a 25% tariff on Chinese goods worth USD 250bn. This evoked a sharp reaction from China that retaliated by levying tariffs of up to 25% on US goods worth USD 60bn, beginning June 2019. Furthermore, the Trump administration announced that Huawei, the Chinese telecommunications giant, and 70 affiliates would be placed on its ‘Entity List’; this means Huawei would now need approval from the federal government before buying parts from US companies. Given its dependence on US suppliers for parts such as chips, this has dealt a major blow to the company. The tit-for-tat approach is sending jitters among market participants and economists while giving fresh fodder to sceptics to press forward their case for an economic downturn.

A full-fledged trade war between the US and China, reminiscent of the Cold War, could result in U.S. imposing tariffs on all goods traded between the two. The resultant tax burden would push cost to a degree that U.S. companies would not be able to countervail them through cost pass-through or cost rationalization, thereby whittling down operating margins. The tax increase would also wipe out most of the long-term gains of the Tax Cuts and Jobs Act. As corporate fundamentals weaken, expansion and investment plans would be shelved, resulting in job cuts. Consumer confidence would take a beating, resulting in reduced consumption. The factors mentioned above could have a domino effect and push the US and (consequently) global economy to the tipping point of a full-blown recession.

Warning signs are reappearing. On May 15, 2019, the treasury yield curve inverted again as the 10-year yield fell below the 3-month yield. The inversion indicates, in case the trade war persists, interest rates are too high currently.

In the short term, given the current economic environment, strong economic growth and stable interest rates, the risk of a recession is low. However, higher prices of Chinese goods (low inflation in the US is obscuring the real price of the trade war) and subsequent constriction of trade with China would hurt the global as well as US economy, upending the global economy’s much-anticipated rebound. The re-building of trade barriers would speed up the pace at which the US economy slips into the next inevitable, and arguably necessary, recession. What is adding to the pessimism is the realization that the Federal Reserve has run out of tools to counter any impending bust, given its decision to leave interest rates steady. The growth in US debt leaves little room for the Fed to undertake monetary expansion.

In light of the growing intransigence and brinkmanship by both parties following the latest round of talks, chances of a trade deal between China and the US have diminished. Nevertheless, we are hopeful that better sense will prevail, paving the way for an amicable settlement. The deciding factor, however, is the time taken to resolve trade issues, as the surrounding uncertainty could be the catalyst that pushes the US (and consequently global) economy over the precipice.