One Step Closer to Recession
As you know by now, the Federal Reserve raised interest rates again yesterday, its eighth increase since the rate hike cycle began in 2015.
In his post-announcement press conference, Jerome Powell cited a strong economy, low unemployment, solid growth, etc. He said that “It’s a particularly bright moment” for the economy.
Barring significant developments, the Fed may raise rates again in December and perhaps three times next year.
Meanwhile, the Commerce Department announced this morning that second quarter U.S. GDP expanded at a 4.2% annualized rate, confirming the earlier estimate.
On the surface it might look everything is great, that it is a particularly bright moment for the economy. But if you take a hard look behind the numbers, a different picture emerges.
A lot of the cheerleaders say Trump’s programs of tax cuts and deregulation will produce persistent trend growth of 3–4% or higher.
Such growth would break decisively with the weak growth of the Obama years. It would also make the U.S. debt burden, currently at 105% of GDP, more sustainable if GDP were to grow faster than the national debt.
There’s one problem with the happy talk about 3–4% growth. We’ve seen it all before.
In 2009, almost every economic forecaster and commentator was talking about “green shoots.” In 2010, then-Secretary of the Treasury Tim Geithner forecast the “recovery summer.” In 2017, the global monetary elites were praising the arrival (at last) of “synchronized global growth.”
None of this wishful thinking panned out. The green shoots turned brown, the recovery summer never came and the synchronized global growth was over almost as soon as it began.
Any signs of trend growth have been strictly temporary (basically moving growth from one quarter to another through inventory and accounting quirks) and are quickly followed by weaker growth. In the first quarter of 2015, growth was 3.2%, but by the fourth quarter that year growth had fallen to a near-recession level of 0.5%.
In the third quarter of 2016 growth was 2.8%, but it fell quickly to 1.2% by the first quarter of 2017. In the third quarter of 2017 growth was 3.2% but then returned to 2.0% by the first quarter of 2018, about the average for the past nine years.
This pattern of temporarily strong growth followed by weak growth has been characteristic of the entire recovery that began in June 2009 and entered its 10th year a few months ago. In fact, we’ve seen even more extreme reversals in the recent past.
In the third quarter of 2013, growth was 4.5%. But by the first quarter of 2014, just six months later, growth was actually negative, -2.1%, comparable to some of the worst quarters in recent recessions.
Growth was 5.0% in the third quarter of 2014, but then fell off a cliff and was barely positive, 0.2%, in the first quarter of 2015.
You get the point. Strong quarters have been followed by much weaker quarters within six months on six separate occasions in the past nine years. There’s no reason to believe this trend will end now.
The longer-term view of the entire recovery is more revealing. The recovery is currently 109 months old, the second-longest since the end of the Second World War. The average recovery since 1980 (a period of longer-than-average expansions) is 83 months.
So this expansion has been extraordinarily long — far longer than average — indicating that a recession should be expected sooner rather than later.
But the current expansion has also been the weakest recovery on record. Average annual growth during this expansion is 2.14%, compared with average annual growth for all expansions since 1980 of 3.21%. That 3.21% figure is what economists mean by “trend” growth.
Even with the latest GDP numbers, the current expansion does not even come close to that trend. The “wealth gap” (the difference between 3.2% trend growth and 2.1% actual growth) is now over $4 trillion. That’s how much poorer the U.S. economy is due to its inability to achieve sustainable trend growth.
As for the Trump bump, growth in the first quarter of 2018 was 2.0%, slightly below the average since June 2009. Growth for all of 2017, Trump’s first year in office, was 2.6%, slightly above the 2.14% average in this recovery but not close to the 3.5% growth proclaimed by Trump’s supporters.
In short, growth under Trump looks a lot like growth under Obama, with no reason to expect that to change anytime soon. In fact, the head winds caused by the strong dollar, the trade wars and out-of-control deficit spending may slow the economy and bring future growth down below the average of the Obama years.
I’ve said repeatedly that the Fed is tightening into weakness. But it’s more than the rate hikes. The Fed is also winding down its balance sheet, and the pace is scheduled to accelerate next year.
Far from printing money, the Fed is destroying base money at a rapid pace. The Fed is basically burning money. They’re doing this by not rolling over maturing Treasury and mortgage securities they hold on their balance sheet. That’s a “double whammy” of tightening.
When a security held by the Fed matures and the issuer pays it off, the money sent to the Fed just disappears. It’s called quantitative tightening, or QT.
When the Fed started QT in late 2017, they urged market participants to ignore it. They said the QT plan was on autopilot, the Fed was not going to use it as an instrument of policy and the money burning would “run on background” just like a computer program that’s open but not in use at the moment.
It’s fine for the Fed to say that, but markets have another view. Analysts estimate that QT is the equivalent of two–four rate hikes per year over and above the explicit rate hikes.
Bearing in mind that monetary policy works with a 12–18-month lag, this extraordinary tightening policy in a weak economy is almost certainly a recipe for a recession.
And expected results are beginning to show up in the markets. Mortgage interest rates are up, mortgage refis are sinking like a stone and housing affordability is suffering.
This will eventually result in fewer new home purchases, slower household formation and a weakening economy. The Fed will have to reverse course and cut rates, or at least “pause” in raising rates much sooner than they think.
The Fed knows a recession will happen sooner rather than later and is desperate to acquire some dry powder (in the form of higher rates and a reduced balance sheet) so it can use it when the time comes.
The problem, of course, is that by pursuing these policies, the Fed will cause the recession it is preparing to cure.
The single most important factor in my analysis is that when the Fed realizes its mistake of tightening into economic weakness, it will have to turn on a dime and shift to an easing policy.
Easing will come first through forward guidance and pauses in the rate hike tempo, then possibly actual rate cuts back to zero and finally reversing their balance sheet reductions by expanding the balance sheet through QE4 if needed.
Jay Powell seems determined to continue rate hikes on an aggressive path and possibly to accelerate the hikes. But he might be in for a severe case of whiplash when he has to make a hard pivot to easing.
But by then, the damage will have been done.
for TheDaily Reckoning