On 10 March, the House of Representatives gave final approval to President Biden’s $1.9tr fiscal stimulus plan (the American Rescue Plan). Worth over 9% of GDP, this represents the third stage of an unparalleled boost to the US economy. In March 2020, President Trump secured congressional agreement for a $2.2tr package (the CARES Act). Then in December 2020, a bipartisan COVID relief bill, worth $902bn, was passed by Congress.
By comparison, the Obama package in 2009 in response to the impending recession following the financial crisis was $831bn (5.7% of GDP).
The American Rescue Plan
The Biden stimulus programme consists of a range of measures, the majority of which provide monetary support to individuals. These include a payment of $1400 per person for single people earning less than $75 000 and couples less than $150 000. These come on top of payments of $1200 in March 2020 and $600 in late December. In addition, the top-up to unemployment benefits of $300 per week agreed in December will now continue until September. Also, annual child tax credit will rise from $2000 annually to as much as $3600 and this benefit will be available in advance.
Other measures include $350bn in grants for local governments depending on their levels of unemployment and other needs; $50bn to improve COVID testing centres and $20bn to develop a national vaccination campaign; $170bn to schools and universities to help them reopen after lockdown; and grants to small businesses and specific grants to hard-hit sectors, such as hospitality, airlines, airports and rail companies.
Despite supporting the two earlier packages, no Republican representative or senator backed this latest package, arguing that it was not sufficiently focused. As a result, reaction to the package has been very much along partisan lines. Nevertheless, it is supported by some 90% of Democrat voters and 50% of Republican voters.
Is the stimulus the right amount?
Although the latest package is worth $1.9tr, aggregate demand will not expand by this amount, which will limit the size of the multiplier effect. The reason is that the benefits multiplier is less than the government expenditure multiplier as some of the extra money people receive will be saved or used to reduce debts.
With $3tr representing some 9% of GDP, this should easily fill the estimated negative output gap of between 2% and 3%, especially when multiplier effects are included. Also, with savings having increased during the recession to put them some 7% above normal, the additional amount saved may be quite small, and wealthier Americans may begin to reduce their savings and spend a larger proportion of their income.
So the problem might be one of excessive stimulus, which in normal times could result in crowding out by driving up interest rates and dampening investment. However, the Fed is still engaged in a programme of quantitative easing. Between mid-March 2020 and the end of March 2021, the Fed’s portfolio of securities held outright grew from $3.9tr to $7.2tr. What is more, many economists predict that inflation is unlikely to rise other than very slightly. If this is so, it should allow the package to be financed easily. Debt should not rise to unsustainable levels.
Other economists argue, however, that inflationary expectations are rising, reflected in bond yields, and this could drive actual inflation and force the Fed into the awkward dilemma of either raising interest rates, which could have a significant dampening effect, or further increasing money supply, potentially leading to greater inflationary problems in the future.
A lot will depend what happens to potential GDP. Will it rise over the medium term so that additional spending can be accommodated? If the rise in spending encourages an increase in investment, this should increase potential GDP. This will depend on business confidence, which may be boosted by the package or may be dampened by worries about inflation.
Additional packages to come
Potential GDP should also be boosted by two further packages that Biden plans to put to Congress.
The first is a $2.2tr infrastructure investment plan, known as the American Jobs Plan. This is a 10-year plan to invest public money in transport infrastructure (such as rebuilding 20 000 miles of road and repairing bridges), public transport, electric vehicles, green housing, schools, water supply, green power generation, modernising the power grid, broadband, R&D in fields such as AI, social care, job training and manufacturing. This will be largely funded through tax increases, such as gradually raising corporation tax from 21% to 28% (it had been cut from 35% to 21% by President Trump) and taxing global profits of US multinationals. However, the spending will generally precede the increased revenues and thus will raise aggregate demand in the initial years. Only after 15 years are revenues expected to exceed costs.
The second is a yet-to-be announced plan to increase spending on childcare, healthcare and education. This should be worth at least $1tr. This will probably be funded by tax increases on income, capital gains and property, aimed largely at wealthy individuals. Again, it is hoped that this will boost potential GDP, in this case by increasing labour productivity.
With earlier packages, the total increase in public spending will be over $8tr. This is discretionary fiscal policy writ large.
- Biden’s $1.9 trillion COVID-19 bill wins final approval in House
Reuters, Susan Cornwell and Makini Brice (10/3/21)
- Biden’s Covid stimulus plan: It costs $1.9tn but what’s in it?
BBC News, Natalie Sherman (6/3/21)
- Biden’s $1.9 Trillion Challenge: End the Coronavirus Crisis Faster
New York Times, Jim Tankersley and Sheryl Gay Stolberg (22/3/21)
- Joe Biden writes a cheque for America – and the rest of the world
The Observer, Phillip Inman (13/3/21)
- Spend or save: Will Biden’s stimulus cheques boost the economy?
Aljazeera, Cinnamon Janzer (9/3/21)
- After Biden stimulus, US economic growth could rival China’s for the first time in decades
CNN, Matt Egan (12/3/21)
- Larry Summers, who called out inflation fears with Biden’s $1.9 trillion COVID-19 relief package, says the US is seeing ‘least responsible’ macroeconomic policy in 40 years
Business Insider, John L. Dorman (21/3/21)
- With $1.9 Trillion in New Spending, America Is Headed for Financial Fragility
Barron’s, Leslie Lipschitz and Josh Felman (30/3/21)
- Biden unveils ‘once-in-a generation’ $2tn infrastructure investment plan
The Guardian, Lauren Gambino (31/3/21)
- Biden unveils $2tn infrastructure plan and big corporate tax rise
Financial Times, James Politi (31/3/21)
- The Observer view on Joe Biden’s audacious spending plans
The Observer, editorial (11/4/21)
- Draw a Keynesian cross diagram to show the effect of an increase in benefits when the economy is operating below potential GDP.
- What determines the size of the benefits multiplier?
- Explain what is meant by the output gap. How might the pandemic and accompanying emergency health measures have affected the size of the output gap?
- How are expectations relevant to the effectiveness of the stimulus measures?
- What is likely to determine the proportion of the $1400 stimulus cheques that people spend?
- Distinguish between resource crowding out and financial crowding out. Is the fiscal stimulus package likely to result in either form of crowding out and, if so, what will determine by how much?
- What is the current monetary policy of the Fed? How is it likely to impact on the effectiveness of the fiscal stimulus?
At its meeting on 6 May, the Bank of England’s Monetary Policy Committee decided to keep Bank Rate at 0.1%. Due to the significant impact of COVID-19 and the measures put in place to try to contain the virus, the MPC voted unanimously to keep Bank Rate the same.
However, it decided not to launch a new stimulus programme, with the committee voting by a majority of 7-2 for the Bank to continue with the current programme of quantitative easing. This involves the purchase of £200 billion of government and sterling non-financial investment-grade corporate bonds, bringing the total stock of bonds held by the Bank to £645 billion.
The Bank forecast that the crisis will put the economy into its deepest recession in 300 years, with output plunging 30 per cent in the first half of the year.
Monetary policy and MPC
Monetary policy is the tool used by the UK’s central bank to influence how much money is in the economy and how much it costs to borrow. The Bank of England’s main monetary policy tools include setting the Bank Rate and quantitative easing (QE). Bank Rate is the interest rate charged to banks when they borrow money from the BoE. QE is the process of creating money digitally to buy corporate and government bonds.
The BoE’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target. Maintaining a low and stable inflation rate is good for the economy and it is the main monetary policy aim. However, the Bank also has to balance this target with the government’s other economic aims of sustaining growth and employment in the economy.
Actions taken by the MPC
It is challenging to respond to severe economic and financial disruption, with the UK economy looking unusually uncertain. Activity has fallen sharply since the beginning of the year and unemployment has risen markedly. The current rate of inflation, measured by the Consumer Price Index (CPI), declined to 1.5% in March and is likely to fall below 1% in the next few months. Household consumption has fallen by around 30% as consumer confidence has declined. Companies’ sales are expected to be around 45% lower than normal and business investment 50% lower.
In the current circumstances, and consistent with the MPC’s remit, monetary policy is aimed at supporting businesses and households through the crisis and limiting any lasting damage to the economy. The Bank has used both main monetary tools to fulfil its mandate and attempt to boost the economy amid the current lockdown. The Bank Rate was reduced to 0.1% in March, the lowest level in the Bank’s 325-year history and the current programme of QE was introduced in March.
What is next?
This extraordinary time has seen the outlook for the all global economies become uncertain. The long-term outcome will depend critically on the evolution of the pandemic, and how governments, households and businesses respond to it. The Bank of England has stated that businesses and households will need to borrow to get through this period and is encouraging banks and building societies to increase their lending. Britain’s banks are warned that if they try to stem losses by restricting lending, they will make the situation worse. The Bank believes that the banks are strong enough to keep lending, which will support the economy and limit losses to themselves.
In the short term, a bleak picture of the UK economy is suggested, with a halving in business investment, a near halving in business sales, a sharp rise in unemployment and households cutting their spending by a third. Despite its forecast that GDP could shrink by 14% for 2020, the Bank of England is forecasting a ‘V’ shaped recovery. In this scenario, the recovery in economic activity, once measures are softened, is predicted to be relatively rapid and inflation rises to around the 2 per cent target. However, this would be after a dip to 0.5% in 2021, before returning to the 2 per cent target the following year.
However, there are some suggestions that the Bank’s forecast for the long-term recovery is too optimistic. Yael Selfin, chief economist at KPMG UK, fears the UK economy could shrink even more sharply than the Bank of England has forecast.
Despite the stark numbers issued by the Bank of England today, additional pressure on the economy is likely. Some social distancing measures are likely to remain in place until we have a vaccine or an effective treatment for the virus, with people also remaining reluctant to socialise and spend. That means recovery is unlikely to start in earnest before sometime next year.
There are also additional factors that could dampen future productivity, such as the impact on supply chains, with ‘just-in-time’ operations potentially being a thing of the past.
There is also the ongoing issue of Brexit. This is a significant downside risk as the probability of a smooth transition to a comprehensive free-trade agreement with the EU in January is relatively small. This will only increase uncertainty for businesses along with the prospect of increased trade frictions next year.
The predictions from the Bank of England are based on many assumptions, one of which is that the economy will only be gradually released from lockdown. Its numbers contain the expectations that consumer and worker behaviour will change significantly, and continue for some time, with forms of voluntary social distancing. On the other hand, Mr Bailey expects the recovery to be much faster than seen with the financial crisis a decade ago. However, again this is based on the assumption that measures put in place from the public health side prevent a second wave of the virus.
It also assumes that the supply-side effects on the economy will be limited in the long run. Many economists disagree, arguing that the ‘scarring effects’ of the lockdown may be substantial. These include lower rates of investment, innovation and start ups and the deskilling effects on labour. They also include the businesses that have gone bankrupt and the dampening effect on consumer and business confidence. Finally, with a large increase in lending to tide firms over the crisis, many will face problems of debt, which will dampen investment.
The Bank of England does recognise these possible scarring effects. Specifically, it warns of the danger of a rise in equilibrium unemployment:
It is possible that the rise in unemployment could prove more persistent than embodied in the scenario, for example if companies are reluctant to hire until they are sure about the robustness of the recovery in demand. It is also possible that any rise in unemployment could lead to an increase in the long‑term equilibrium rate of unemployment. That might happen if the skills of the unemployed do not increase to the same extent as they would if they were working, for example, or even erode over time.
What is certain, however, is that the long-term picture will only become clearer when we start to come out of the crisis. Bailey implied that the Bank is taking a wait-and-see approach for now, waiting on the UK government to shed some light about easing of lockdown measures before taking any further action with regards to QE. The MPC will continue to monitor the situation closely and, consistent with its remit, stands ready to take further action as necessary to support the economy and ensure a sustained return of inflation to the 2% target. Paul Dales, chief UK economist at Capital Economics, suggested that the central bank is signalling that ‘more QE is coming, if not in June, then in August’.
Bank of England publication
- How could the BoE use monetary policy to boost the economy?
- Explain how changes in interest rates affect aggregate demand.
- Define and explain quantitative easing (QE).
- How might QE help to stimulate economic growth?
- How is the pursuit of QE likely to affect the price of government bonds? Explain.
- Evaluate the extent to which monetary policy is able to stimulate the economy and achieve price stability.
Donald Trump has suggested that the Fed should cut interest rates by 1 percentage point and engage in a further round of quantitative easing. He wants to see monetary policy used to give a substantial boost to US economic growth at a time when inflation is below target. In a pair of tweets just before the meeting of the Fed to decide on interest rates, he said:
China is adding great stimulus to its economy while at the same time keeping interest rates low. Our Federal Reserve has incessantly lifted interest rates, even though inflation is very low, and instituted a very big dose of quantitative tightening. We have the potential to go up like a rocket if we did some lowering of rates, like one point, and some quantitative easing. Yes, we are doing very well at 3.2% GDP, but with our wonderfully low inflation, we could be setting major records &, at the same time, make our National Debt start to look small!
But would this be an appropriate policy? The first issue concerns the independence of the Fed.
It is supposed to take decisions removed from the political arena. This means sticking to its inflation target of 2 per cent over the medium term – the target it has officially had since January 2012. To do this, it adjusts the federal funds interest rate and the magnitude of any bond buying programme (quantitative easing) or bond selling programme (quantitative tightening).
The Fed is supposed to assess the evidence concerning the pressures on inflation (e.g. changes in aggregate demand) and what inflation is likely to be over the medium term in the absence of any changes in monetary policy. If the Federal Open Market Committee (FOMC) expects inflation to exceed 2 per cent over the medium term, it will probably raise the federal funds rate; if it expects inflation to be below the target it will probably lower the federal funds rate.
In the case of the economy being in recession, and thus probably considerably undershooting the target, it may also engage in quantitative easing (QE). If the economy is growing strongly, it may sell some of its portfolio of bonds and thus engage in quantitative tightening (QT).
Since December 2015 the Fed has been raising interest rates by 0.25 percentage points at a time in a series of steps, so that the federal funds rate stands at between 2.25% and 2.5% (see chart). And since October 2017, it has also been engaged in quantitative tightening. In recent months it has been selling up to $50 billion of assets per month from its holdings of around $4000 billion and so far has reduced them by around £500 billion. It has, however, announced that the programme of QT will end in the second half of 2019.
This does raise the question of whether the FOMC is succumbing to political pressure to cease QT and put interest rate rises on hold. If so, it is going against its remit to base its policy purely on evidence. The Fed, however, maintains that its caution reflects uncertainty about the global economy.
The second issue is whether Trump’s proposed policy is a wise one.
Caution about further rises in interest rates and further QT is very different from the strongly expansionary monetary policy that President Trump proposes. The economy is already growing at 3.2%, which is above the rate of growth in potential output, of around 1.8% to 2.0%. The output gap (the percentage amount that actual GDP exceeds potential GDP) is positive. The IMF forecasts that the gap will be 1.4% in 2019 and 1.3% in 2020 and 2021. This means that the economy is operating at above normal capacity working and this will eventually start to drive up inflation. Any further stimulus will exacerbate the problem of excess demand. And a large stimulus, as proposed by Donald Trump, will cause serious overheating in the medium term, even if it does stimulate growth in the short term.
For these reasons, the Fed resisted calls for a large cut in interest rates and a return to quantitative easing. Instead it chose to keep interest rates on hold at its meeting on 1 May 2019.
But if the Fed had done as Donald Trump would have liked, the economy would probably be growing very strongly at the time of the next US election in November next year. It would be a good example of the start of a political business cycle – something that is rarer nowadays with the independence of central banks.
- What are the arguments for central bank independence?
- Are there any arguments against central bank independence?
- Explain what is meant by an ‘output gap’? Why is it important to be clear on what is meant by ‘potential output’?
- Would there be any supply-side effects of a strong monetary stimulus to the US economy at the current time? If so, what are they?
- Explain what is meant by the ‘political business’ cycle? Are governments in the UK, USA or the eurozone using macroeconomic policy to take advantage of the electoral cycle?
- The Fed seems to be ending its programme of quantitative tightening (QT). Why might that be so and is it a good idea?
- If inflation is caused by cost-push pressures, should central banks stick rigidly to inflation targets? Explain.
- How are expectations likely to affect the success of a monetary stimulus?
Growth in the eurozone has slowed. The European Central Bank (ECB) now expects it to be 1.1% this year; in December, it had forecast a rate of 1.7% for 2019. Mario Draghi, president of the ECB, in his press conference, said that ‘the weakening in economic data points to a sizeable moderation in the pace of the economic expansion that will extend into the current year’. Faced with a slowing eurozone economy, the ECB has announced further measures to stimulate economic growth.
First it has indicated that interest rates will not rise until next year at the earliest ‘and in any case for as long as necessary to ensure the continued sustained convergence of inflation to levels that are below, but close to, 2% over the medium term’. The ECB currently expects HIPC inflation to be 1.2% in 2019. It was expected to raise interest rates later this year – probably by the end of the summer. The ECB’s main refinancing interest rate, at which it provides liquidity to banks, has been zero since March 2016, and so there was no scope for lowering it.
Second, although quantitative easing (the asset purchase programme) is coming to an end, there will be no ‘quantitative tightening’. Instead, the ECB will purchase additional assets to replace any assets that mature, thereby leaving the stock of assets held the same. This would continue ‘for an extended period of time past the date when we start raising the key ECB interest rates, and in any case for as long as necessary to maintain favourable liquidity conditions and an ample degree of monetary accommodation’.
Third, the ECB is launching a new series of ‘quarterly targeted longer-term refinancing operations (TLTRO-III), starting in September 2019 and ending in March 2021, each with a maturity of two years’. These are low-interest loans to banks in the eurozone for use for specific lending to businesses and households (other than for mortgages) at below-market rates. Banks will be able to borrow up to 30% of their eligible assets (yet to be fully defined). These, as their acronym suggests, are the third round of such loans. The second round was relatively successful. As the Barron’s article linked below states:
Banks boosted their long-term borrowing from the ECB by 70% over the course of the program, although they did not manage to increase their holdings of business loans until after TLTRO II had finished disbursing funds in March 2017.
Whether these measures will be enough to raise growth rates in the eurozone depends on a range of external factors affecting aggregate demand. Draghi identified three factors which could have a negative effect.
- Brexit. The forecasts assume an orderly Brexit in accordance with the withdrawal deal agreed between the European Commission and the UK government. With the House of Commons having rejected this deal twice, even though it has agreed that there should not be a ‘no-deal Brexit’, this might happen as it is the legal default position. This could have a negative effect on the eurozone economy (as well as a significant one on the UK economy). Even an extension of Article 50 could create uncertainty, which would also have a negative effect
- Trade wars. If President Trump persists with his protectionist policy, this will have a negative effect on growth in the eurozone and elsewhere.
- China. Chinese growth has slowed and this dampens global growth. What is more, China is a major trading partner of the eurozone countries and hence slowing Chinese growth impacts on the eurozone through the international trade multiplier. The ECB has taken this into account, but if Chinese growth slows more than anticipated, this will further push down eurozone growth.
Then there are internal uncertainties in the eurozone, such as the political and economic uncertainty in Italy, which in December 2018 entered a recession (2 quarters of negative economic growth). Its budget deficit is rising and this is creating conflict with the European Commission. Also, there are likely to be growing tensions within Italy as the government raises taxes.
Faced with these and other uncertainties, the measures announced by Mario Draghi may turn out not to be enough. Perhaps in a few months’ there may have to be a further round of quantitative easing.
- ECB statement following policy meeting
Reuters, Larry King (7/3/19)
- European Central Bank acts to boost struggling eurozone
BBC News, Andrew Walker (7/3/19)
- The European Central Bank Tries to Avoid Repeating Past Mistakes
Barron’s, Matthew C. Klein (8/3/19)
- ECB pushes back rate hike plans, announces fresh funding for banks
CNBC, Silvia Amaro (7/3/19)
- Why the ECB Followed the Fed’s Flip-Flopping
Bloomberg, Mohamed A. El-Erian (7/3/19)
- Central Banks Don’t Have the Answer and Markets Know It
Bloomberg, Robert Burgess (7/3/19)
- Missing out on monetary normalisation
OMFIF, David Marsh (12/4/19)
- The ECB is attempting to get ahead of event
Financial Times, The editorial board (8/3/19)
- Explainer: What is the fuss about European Central Bank TLTRO loans?
Reuters, Balazs Koranyi (4/3/19)
- Investigate the history of quantitative easing and its use by the Fed, the Bank of England and the ECB. What is the current position of the three central banks on ‘quantitative tightening’, whereby central banks sell some of the stock of assets they have purchased during the process of quantitative easing or not replace them when they mature?
- What are TLTROs and what use of them has been made by the ECB? Do they involve the creation of new money?
- What will determine the success of the proposed TLTRO III scheme?
- If the remit of central banks is to keep inflation on target, which in the ECB’s case means below 2% HIPC inflation but close to it over the medium term, why do people talk about central banks using monetary policy to revive a flagging economy?
- What is ‘forward guidance’ by central banks and what determines its affect on aggregate demand?
It is impossible to make both precise and accurate forecasts of a country’s rate of economic growth, even a year ahead. And the same goes for other macroeconomic variables, such as the rate of unemployment or the balance of trade. The reason is that there are so many determinants of these variables, such as political decisions or events, which themselves are unpredictable. Economics examines the effects of human interactions – it is a social science, not a natural science. And human behaviour is hard to forecast.
Nevertheless, economists do make forecasts. These are best estimates, taking into account a number of determinants that can be currently measured, such as tax or interest rate changes. These determinants, or ‘leading indicators’, have been found to be related to future outcomes. For example, surveys of consumer and business confidence give a good indication of future consumer expenditure and investment – key components of GDP.
Leading indicators do not have to be directly causal. They could, instead, be a symptom of underlying changes that are themselves likely to affect the economy in the future. For example, changes in stock market prices may reflect changes in confidence or changes in liquidity. It is these changes that are likely to have a direct or indirect causal effect on future output, employment, prices, etc.
Macroeconomic models show the relationships between variables. They show how changes in one variable (e.g. increased investment) affect other variables (e.g. real GDP or productivity). So when an indicator changes, such as a rise in interest rates, economists use these models to estimate the likely effect, assuming other things remain constant (ceteris paribus). The problem is that other things don’t remain constant. The economy is buffeted around by a huge range of events that can affect the outcome of the change in the indicator or the variable(s) it reflects.
Forecasting can never therefore be 100% accurate (except by chance). Nevertheless, by carefully studying leading indicators, economists can get a good idea of the likely course of the economy.
Leading indicators of the US economy
At the start of 2019, several leading indicators are suggesting the US economy is likely to slow and might even go into recession. The following are some of the main examples.
Political events. This is the most obvious leading indicator. If decisions are made that are likely to have an adverse effect on growth, a recession may follow. For example, decisions in the UK Parliament over Brexit will directly impact on UK growth.
As far as the USA is concerned, President Trump’s decision to put tariffs on steel and aluminium imports from a range of countries, including China, the EU and Canada, led these countries to retaliate with tariffs on US imports. A tariff war has a negative effect on growth. It is a negative sum game. Of course, there may be a settlement, with countries agreeing to reduce or eliminate these new tariffs, but the danger is that the trade war may continue long enough to do serious damage to global economic growth.
But just how damaging it is likely to be is impossible to predict. That depends on future political decisions, not just those of the recent past. Will there be a global rise in protectionism or will countries pull back from such a destructive scenario? On 29 December, President Trump tweeted, ‘Just had a long and very good call with President Xi of China. Deal is moving along very well. If made, it will be very comprehensive, covering all subjects, areas and points of dispute. Big progress being made!’ China said that it was willing to work with the USA over reaching a consensus on trade.
Rises in interest rates. If these are in response to a situation of excess demand, they can be seen as a means of bringing inflation down to the target level or of closing a positive output gap, where real national income is above its potential level. They would not signify an impending recession. But many commentators have interpreted rises in interest rates in the USA as being different from this.
The Fed is keen to raise interest rates above the historic low rates that were seen as an ’emergency’ response to the financial crisis of 2007–8. It is also keen to reverse the policy of quantitative easing and has begun what might be described as ‘quantitative tightening’: not buying new bonds when existing ones that it purchased during rounds of QE mature. It refers to this interest rate and money supply policy as ‘policy normalization‘. The Fed maintains that such policy is ‘consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term’.
However, many commentators, including President Trump, have accused the Fed of going too fast in this process and of excessively dampening the economy. It has already raised the Federal Funds Rate nine times by 0.25 percentage points each time since December 2015 (click here for a PowerPoint file of the chart). What is more, announcing that the policy will continue makes such announcements themselves a leading indicator of future rises in interest rates, which are a leading indicator of subsequent effects on aggregate demand. The Fed has stated that it expects to make two more 0.25 percentage point rises during 2019.
Surveys of consumer and business confidence. These are some of the most significant leading indicators as consumer confidence affects consumer spending and business confidence affects investment. According to the Duke CFO Global Business Outlook, an influential survey of Chief Financial Officers, ‘Nearly half (48.6 per cent) of US CFOs believe that the US will be in recession by the end of 2019, and 82 per cent believe that a recession will have begun by the end of 2020’. Such surveys can become self-fulfilling, as a reported decline in confidence can itself undermine confidence as both firms and consumers ‘catch’ the mood of pessimism.
Stock market volatility. When stock markets exhibit large falls and rises, this is often a symptom of uncertainty; and uncertainty can undermine investment. Stock market volatility can thus be a leading indicator of an impending recession. One indicator of such volatility is the VIX index. This is a measure of ’30-day expected volatility of the US stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPXSM) call and put options. On a global basis, it is one of the most recognized measures of volatility – widely reported by financial media and closely followed by a variety of market participants as a daily market indicator.’ The higher the index, the greater the volatility. Since 2004, it has averaged 18.4; from 17 to 28 December 2018, it averaged 28.8. From 13 to 24 December, the DOW Jones Industrial Average share index fell by 11.4 per cent, only to rise by 6.2 per cent by 27 December. On 26 December, the S&P 500 index rallied 5 per cent, its best gain since March 2009.
Not all cases of market volatility, however, signify an impending recession, but high levels of volatility are one more sign of investor nervousness.
Oil prices. When oil prices fall, this can be explained by changes on the demand and/or supply side of the oil market. Oil prices have fallen significantly over the past two months. Until October 2018, oil prices had been rising, with Brent Crude reaching $86 per barrel by early October. By the end of the year the price had fallen to just over $50 per barrel – a fall of 41 per cent. (Click here for a PowerPoint file of the chart.) Part of the explanation is a rise in supply, with shale oil production increasing and also increased output from Russia and Saudi Arabia, despite a commitment by the two countries to reduce supply. But the main reason is a fall in demand. This reflects both a fall in current demand and in anticipated future demand, with fears of oversupply causing oil companies to run down stocks.
Falling oil prices resulting from falling demand are thus an indicator of lack of confidence in the growth of future demand – a leading indicator of a slowing economy.
The yield curve. This depicts the yields on government debt with different lengths to maturity at a given point in time. Generally, the curve slopes upwards, showing higher rates of return on bonds with longer to maturity. This is illustrated by the blue line in the chart. (Click here for a PowerPoint file of the chart.) This is as you would expect, with people requiring a higher rate of return on long-term lending, where there is normally greater uncertainty. But, as the Bloomberg article, ‘Don’t take your eyes off the yield curve‘ states:
Occasionally, the curve flips, with yields on short-term debt exceeding those on longer bonds. That’s normally a sign investors believe economic growth will slow and interest rates will eventually fall. Research by the Federal Reserve Bank of San Francisco has shown that an inversion has preceded every US recession for the past 60 years.
The US economy is 37 quarters into what may prove to be its longest expansion on record. Analysts surveyed by Bloomberg expect gross domestic product growth to come in at 2.9 percent this year, up from 2.2 percent last year. Wages are rising as unfilled vacancies hover near all-time highs.
With times this good, the biggest betting game on Wall Street is when they’ll go bad. Barclays Plc, Goldman Sachs Group Inc., and other banks are predicting inversion will happen sometime in 2019. The conventional wisdom: Afterward it’s only a matter of time – anywhere from 6 to 24 months – before a recession starts.
As you can see from the chart, the yield curve on 24 December 2018 was still slightly upward sloping (expect between 6-month and 1-year bonds) – but possibly ready to ‘flip’.
However, despite the power of an ‘inverted’ yield in predicting previous recessions, it may be less reliable now. The Fed, as we saw above, has already signalled that it expects to increase short-term rates in 2019, probably at least twice. That alone could make the yield curve flatter or even downward sloping. Nevertheless, it is still generally thought that a downward sloping yield curve would signal belief in a likely slowdown, if not outright recession.
So, is the USA heading for recession?
The trouble with indicators is that they suggest what is likely – not what will definitely happen. Governments and central banks are powerful agents. If they believed that a recession was likely, then fiscal and monetary policy could be adjusted. For example, the Fed could halt its interest rate rises and quantitative tightening, or even reverse them. Also, worries about protectionism may subside if the USA strikes new trade deals with various countries, as it did with Canada and Mexico in USMCA.
- A jarring new survey shows CEOs think a recession could strike as soon as year-end 2019
Business Insider, Joe Ciolli (17/12/18)
- 4 Recession Indicators to Watch Now
Barron’s, Campbell Harvey (20/12/18)
- 9 Reasons the US Will Have a Recession Next Year
24/7 Wall St, Douglas A. McIntyre (26/12/18)
- The global economy is living dangerously – but don’t expect superpowers to follow the 2008 script
Independent, Ben Chu (3/1/19)
- Could a recession be just around the corner?
The Conversation, Amitrajeet A Batabyal (6/12/18)
- The US is on the edge of the economic precipice – Trump may push it over
The Guardian, Robert Reich (23/12/18)
- US prepares to hit the wall as reckless Trump undoes years of hard work
The Guardian, (Business Leader) (23/12/18)
- The first signs of the next recession
New Statesman, Helen Thompson (23/11/18)
- Is a Recession Coming? CFOs Predict 2019 Recession, Majority Expect Pre-2020 Market Crash
Newsweek, Benjamin Fearnow (12/12/18)
- Trade slowdown coming at worst time for world economy, markets
Reuters, Jamie McGeever (19/12/18)
- How to spot the next recession
The Week, Jeff Spross (27/11/18)
- What Is a Recession, and Why Are People Talking About the Next One?
New York Times, Niraj Chokshi (17/12/180
- For the American Economy, Storm Clouds on the Horizon
New York Times, Binyamin Appelbaum (28/11/18)
- Don’t Take Your Eyes Off the Yield Curve
Bloomberg Businessweek, Liz McCormick and Jeanna Smialek (16/11/18)
- What to expect from 2019’s ‘post-peak’ economy
CNN, Larry Hatheway (19/12/18)
- Worried about the next recession? Here’s what to watch instead of the yield curve
Quartz, Gwynn Guilford (17/12/18)
- Leading Economic Indicators and How to Use Them
The Balance, Kimberly Amadeo (10/9/18)
Surveys and Data
- Define the term ‘recession’.
- Are periods of above-trend expansion necessarily followed by a recession?
- Give some examples of leading indicators other than those given above and discuss their likely reliability in predicting a recession.
- Find out what has been happening to confidence levels in the EU over the past 12 months. Does this provide evidence of an impending recession in the EU?
- For what reasons may there be lags between a change in an indicator and a change in the variables for which it is an indicator?
- Why has the shape of the yield curve previously been a good predictor of the future course of the economy? Is it likely to be at present?
- What is the relationship between interest rates, government bond prices (‘Treasuries’ in the USA) and the yield on such bonds?