How Young Is the US Expansion?

Summary

• Low unemployment suggests the ongoing expansion could be more mature than its duration alone suggests.
• Continued, if slower, disinflation (i.e., no recession) remains my base case for 2024. However, Donald Trump winning the election could lead to inflationary policies, Federal Reserve (Fed) tightening, and recession in 2025-26.
• Under more conventional macro policies, the expansion could be more at risk from financial imbalances than inflation. For instance, through a repricing of fiscal sustainability risks or instability in the shadow banking sector.

Market Implications

• Because I see a low risk of a 2024 recession, I expect the Fed to start cutting in June, in line with market expectations.

Expansion More Mature Than Its Duration Implies

What can we learn from US recessions since the 1960s? And do they have any relevance on our current situation?

Since 1960, the US has gone through nine recessions, lasting on average three quarters (Chart 1 and Table 1).

The expansion preceding the 2020 recession lasted 128 months and was the longest on record since 1857, based on the NBER’s chronology.

Compared, the current expansion is only 46 months old. However, the longevity of the pre-pandemic expansion largely reflects the very high unemployment prevailing post-GFC and the following sluggish growth. This is a feature of the ‘Great Moderation’ (Chart 1): since the 1981-82 recession, expansions have lasted longer, but that is largely due to slow employment recoveries from recessions.

This time, the employment recovery has been fast due to the strong policy response. As a result, unemployment has been below 4% since February 2022 (i.e., for 24 months).

Since 1960, there have been only two previous instances of unemployment below 4% (Chart 2):

• April 2018, with the pandemic recession 22 months later. It is unknown how long the expansion would have continued absent the pandemic, a completely exogenous event.
• February 1966, with a recession 45 months later in December 1969 as the Fed tightened in response to accelerating inflation.

An inflation-driven recession seems unlikely in 2024 but could be a 2025-26 risk.

Inflation-Driven Recession Unlikely in 2024

I think disinflation will likely continue, if more slowly, which makes an inflation-driven recession unlikely.

Compared with the 1960s, the Fed has been much more proactive this time as the FFR above the Taylor rule shows (Chart 3). Inflation expectations are also better anchored this time.  Furthermore, positive supply shocks, namely increased labour supply and falling energy prices have supported disinflation. While fiscal policy is looser than in the 1960s, an improving current account suggests a positive private sector savings investment balance is offsetting the negative government balance.

Weak private sector demand is a structural feature of the low inflation environment prevailing since the late 1990s. For instance, the business sector savings investment balance has turned positive since the early 2000s (i.e., businesses are using a greater share of their surpluses to buy financial rather than real assets). This likely reflects higher returns on the former than the latter, with loose Fed policy boosting returns on financial assets.

Income distribution also still favours profits, which increased to historical highs during the pandemic (Chart 4). With the propensity to save more from profits than wage income, a greater profit share increases desired savings, which can be self-defeating as John Keynes famously argued.

This disinflationary setup may end. Trump’s polling success suggests workers’ income share could be near its political limit. Trump winning the presidential election could lead to inflationary policies, Fed tightening, and recession. However, this would be a 2025-26 risk.

A second Joe Biden administration would likely implement ‘status quo’ economic policies such as limited fiscal consolidation. In this scenario, the expansion could be more at risk from financial imbalances than inflation.

Financial Instability to Cause the Next Recession?

Since the 1990s, recessions are no longer driven by inflation. Core PCE was 1.9% at the outset of the 2001 recession and 2.4% just before the GFC.

Instead, financial imbalances now drive recessions, typically an increase in the credit gap (the deviation of the ratio of credit to GDP from its long-term average, Chart 3). The GFC was famously driven by excessive household leverage and an overhang of residential investment, which experienced an unprecedented contraction (Table 2).

A capex (non-residential investment) overhang and business deleveraging drove the 2001 recession, with demand weaknesses concentrated in capex (Table 2).

The 1990-91 recession was a hybrid: inflation was above 4% but falling and the contraction was partly the result of the 1980s S&L crisis, as shown by a large residential investment contraction.

I think we have passed through the first stage of financial instability with the spring bank failures. The failures exposed the inefficiencies of the post-GFC regulatory regime, with overly complex rules burdening banks, large regulatory bond and cash holdings requirements, unclear viability of smaller banks, and a business model reliant on depositors’ unresponsiveness to low interest rates.

The Fed quickly set up a liquidity facility and the FDIC made all depositors whole and basically extended an implicit guarantee to every bank depositor. This has stabilized the banking system but not addressed its underlying weaknesses.

Where could the next phase of financial instability come from? By contrast, with the private sector, government leverage has increased sharply since the pandemic while banks bond holdings remain high (Chart 6). Repricing fiscal sustainability risks could inflict more bank losses.

Alternatively, the shadow banking system (i.e., credit from sources other than depository institutions) remains twice as large as the banking system and could also cause instability.  Unlike banks, shadow banks do not have access to Fed facilities, are less transparent, and not subjected to the same supervisory oversight.

Market Consequences

I see low risks of a 2024 recession. I therefore expect the pace of disinflation and of convergence of GDP and employment growth to that trend to drive Fed policy in 2024.

I still expect no cut in March and instead expect a May or June cut. To cut, the Fed would likely require continued disinflation, core services PCE and wage growth to be on a downward trend, and GDP growth to be near the long-term trend of 2% than the current 2.9% (Atlanta Fed nowcast). These conditions are more likely to be fulfilled in June than May, which is why I see a June cut as more likely than a May one, in line with market pricing.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)