Fiscal Boost, Monetary Offset
The most notable development since we first published our recession forecast has been the evolution of fiscal policy, including the passage of the Tax Cuts and Jobs Act and the Bipartisan Budget Act of 2018. This combination of tax cuts and higher government spending will provide a sizable boost to economic growth in the near term, with the impact peaking in 2019 at more than 50 basis points. This fiscal boost should offset some of the private sector slowdown and could extend the expansion by several months, all else equal.
However, the impact of fiscal changes on the length of the business cycle should not be overstated for several reasons. First, the fiscal impulse is frontloaded into 2018 and 2019, with our projections showing that fiscal policy will turn into a drag on economic activity beginning in 2020 as government spending caps kick in. Political dynamics also come into play here, as it is beginning to appear increasingly likely that Democrats will take control of the House in the November 2018 midterm elections. Such an outcome would reinforce our expectation that fiscal policy will be less supportive in 2020, as Democrats could see it as advantageous to reinstate the spending caps ahead of the presidential election in November 2020.
The other reason that fiscal policy only marginally changes our recession outlook is our view on the future response of monetary policy. At a time when the unemployment rate is well below full employment and inflation is accelerating, the Federal Reserve (Fed) is already on a course to tighten policy in order to cool the economy. Fiscal stimulus has only served to elevate concerns about economic overheating, meaning that the Fed will likely lean harder against much of the boost from tax cuts and government spending in the form of higher interest rates.
One other policy development worth noting is trade policy, which has come back into focus with the announcement of steel and aluminum tariffs and plans to target China. While we anticipate further U.S. actions on trade, at this point a recession-inducing trade war remains a tail risk scenario, and is not in our baseline forecast.
Extra Runway for the Economy?
The data outlined in our Recession Dashboard has evolved largely as expected over the past few months, with a tighter labor market, Fed rate hikes, a flattening yield curve, and no imminent signs of an inflection point in economic activity.
One notable development has been the stability of the unemployment rate, which has remained unchanged at 4.1 percent for the past six months through March. This leveling out has occurred not because job gains have slowed, but because labor force participation has picked up. Most encouraging has been the rise in the “prime age” 25–54 year-old participation rate, which has risen by 50 basis points since October, a historically strong increase. The combination of rising participation and still-moderate wage pressures suggests that the labor market has some additional room to run, although we expect the unemployment rate will soon resume its decline and will end the year at 3.5 percent.
One other factor suggesting the economy may have some extra runway (making a recession more likely in 2020 than 2019) is the evolution of the natural rate of interest, also known as r-star or r*. The natural rate is the real interest rate that is neither contractionary nor stimulative for the economy, so a higher natural rate means that the Fed has some additional room to raise rates before slowing the economy. We believe that the estimated natural rate is likely to rise from its current level of near-zero, due to the combination of higher fiscal spending, a modest tax cut-induced productivity boost, a stronger global economy, and some easing of financial regulation.
Our assessment of these changes suggests that the Fed may be able to raise rates by an additional 25–50 basis points relative to our prior view, which again points to early 2020 as a more likely recession start date compared to late 2019. Consistent with our expectation for a longer expansion and larger hiking cycle, we now see the terminal fed funds target range at 3.25–3.50 percent, with the Fed likely to deliver four 25 basis point rate increases in both 2018 and 2019. There are signs that the market’s estimate of r* has also risen, as seen in the rise in long-term forward rates in recent months. This has helped keep the three-month 10-year Treasury yield curve, a key input in our recession model and dashboard, relatively stable since our last publication.
Conclusion
While there has been a lot of good economic news in recent months, we still believe the economy is in a late cycle phase, with a recession likely to begin in approximately two years. We expect the yield curve to continue to bear flatten in coming quarters, with the rise in yields being led by the front end of the Treasury curve amid quarterly Fed rate increases and large increases in short-dated Treasury supply.
As we laid out in our previous report, now is the time to begin upgrading credit quality, given the asymmetry of risks that tight corporate bond spreads represent with the next downturn approaching and the historical tendency for corporate bond spreads to trough before equities peak. Indeed, 2018 should be a strong year for stocks, as is typical in the penultimate year of an expansion. Investors should turn more cautious in 2019, however, as equity market peaks typically occur several months before recessions begin.
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