The U.S. economy is in its longest economic expansion on record. The unemployment rate fell to a 50-year low of 3.5% in September (Figure 1).
Unemployment is a good way of observing the economic cycle. It is not exactly correlated with economic growth, but it gives a good picture of demand conditions and it reflects most people’s perception of the state of the economy [i]. To understand why this cycle has been so long in the U.S., we need a theory of why recessions happen.
Typically, after a period of sustained above-trend economic growth, aggregate demand catches up with aggregate supply and inflation begins to rise. Interest rates move up to control prices, but often not quickly enough because poor economic data create policy lags. “Explosive” late-cycle growth sets in mainly due to over-aggressive lending by banks [ii] and often in response to buoyant real estate conditions or high rates of new business creation. Inflation rises sharply and interest rates must play a quick game of catch up. Economic activity slows and a realization occurs in the banking business or household sectors that debts cannot be repaid as planned. A recession ensues.
Why Not This Time?
The answer lies in low inflation and a sustained period of below-trend growth. In the U.S., three negative demand shocks and two positive supply shocks have created a slow but sustainable economic expansion, in which inflation has not shown up.
Three Negative Demand Shocks:
The Eurozone Crisis of 2011 to 2012
Following a brief recovery from the Great Recession, the eurozone economy entered a multi-year economic downturn as several members looked likely to default on sovereign debt obligations. Inflation dipped below 1%. Consumer and business confidence dropped in the U.S. and the softness affected U.S. exports in 2012 and 2013. It also weighed on the U.S. stock market and bank lending (Figure 3).
The 2015-16 Oil Price Slump & U.S. Dollar Surge
The growth of U.S. oil and gas production is a very big deal for the global economy. In the early stages (2010-2014), it created a surge in capital expenditures that helped drive the U.S. economic recovery. However, when oil prices slumped in 2014 due to a global build-up of supply, some very negative consequences set in for the U.S. economy (Figure 4). The dollar surged [iii], causing exports and capital expenditures to decline. A very weak period of GDP growth ensued, and the U.S. came close to recession (Figure 5).
The Trade War & Manufacturing Recession of 2018
A decline in corporate confidence due to the U.S.-China trade war and the possibility of a hard Brexit has clearly lessened capital expenditures and manufacturing output. The rise of populism has had negative consequences for the economy and potentially the fortunes of the average citizen. However, it is not the only factor at play. An as-yet poorly explained downturn in the global auto industry is also at work, as are the ongoing difficulties at Boeing in the wake of the 737 Max debacle.
The Rise of the Sharing Economy Since 2009
Led by millennials and Gen Z, and facilitated by technology, consumers have developed a penchant for sharing cars, bikes, clothes, hotel rooms, workspace and even homes for the sake of cost-savings and sustainability. As well as opening a broader range of consumer choices, the “sharing” economy allowed a more intense use of society’s supply of capital, whether it be for clothing, vehicles or real estate (Figure 8). Greater output for the same level of input is deflationary.
How Long Can It Go On?
The answer is probably quite a while. Mediocre aggregate demand alongside aggressively expanding supply has totally suppressed inflation. The Fed has latitude not just to cut rates to support economic growth, but to engage in further open-market activities if necessary. It might be that further monetary stimulus will, and possibly already has, created asset-price booms in stocks and the technology and commercial real estate sectors. But this does not accord with generally solid fundamentals in each of these markets. One of the benefits of slow and volatile growth is that, despite low interest rates, it has prevented the kind of heedless risk-taking behavior that typically emerges late in the economic cycle. For once, there is no overhang of speculative real estate!
What Could Bring It To An End?
A very major Middle Eastern war that impacts oil supply might do it. A major military confrontation between the U.S. and China, perhaps over Taiwan, would also be very problematic. Alternatively, a further wave of radical populism leading to anti-trade policies might further undermine corporate sentiment and the stock market. Even after 10 years of growth, the U.S. economy has yet to substantively lift the living standard of working-class people. A hard Brexit, and/or a further fracturing of the Euro Area also would be highly disruptive. But it is very hard at this stage to see an interest-rate-generated recession due to rising inflation. This is a quite different situation to any of the last four cycles in the last forty years.
By Richard Barkham, Global Chief Economist and Wei Luo, Associate Director, CBRE.
[i] See the close relationship between unemployment and the rate of real estate vacancy, and for that matter the VIX index (Appendix).
[ii] Over aggressive lending is specifically linked to implicit deposit insurance. Put simply, the banks know that they are too big to fail, so they pursue market share growth. This lending is often linked to an asset bubble in real estate or another sector of the economy, but the bubbles are the result, not the cause of perverse incentives in the banking system.
[iii] There is an inverse relationship between the price of oil and the value of the dollar.