Is Economic Winter Coming?

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RAGHURAM G. RAJAN

CHICAGO – What could trigger a recession in the United States? In the past, a tightening labor market after a period of expansion served as an early warning sign. Workers would become more difficult to find, wages would start climbing, corporate profit margins would tend to shrink, and firms would start raising prices. Fearing inflation, the central bank would then raise interest rates, which in turn would depress corporate investment and spur layoffs.

At this point, aggregate demand would fall as consumers, fearing for their jobs, reduced their spending. Corporate inventories would then rise, and production would be cut further. Growth would slow significantly, signaling the beginning of a recession. This cycle would then be followed by a recovery. After firms worked down their inventories, they would start producing more goods again; and once inflation had abated, the central bank would cut interest rates to boost demand.

But this description seems to apply to a bygone era. Because inflation is now persistently muted, it is no longer a reliable trigger for interest-rate hikes and the slowdowns that followed. More recent recessions have been precipitated instead by financial excesses accumulated during the expansion. In 2001, the excess was in stock-price growth during the dot-com boom; in 2007-2008, it was in financial-sector leverage following the subprime mortgage boom. And while rate hikes by the US Federal Reserve preceded these recessions, they were not responses to above-target inflation, but rather attempts to normalize monetary policy before inflation actually took off.

Inflation today is still below the Fed’s target, and anticipatory tightening is not even on the table (for a variety of reasons). When the Fed embarked on raising rates last year, US President Donald Trump’s administration doubled down on its trade war. After markets started tumbling in late 2018, the Fed backed off. With a comprehensive deal to resolve the trade war nowhere in sight, and with a formal impeachment inquiry into Trump now underway, the Fed is unlikely to tighten monetary policy anytime soon.

Moreover, Trump has made it clear that he will blame the Fed in the event of a recession. Having calculated that the reputational risks of slightly higher inflation are smaller than those associated with a downturn after a rate hike, the Fed will not be inclined to raise rates for the time being. Instead, it has cut rates three times in 2019 to “buy insurance” against a downturn. Besides, the Fed has been emphasizing that its inflation target is “symmetric,” meaning that it would be willing to tolerate a period of above-target inflation, given that it has undershot the target in recent years, before intervening.

If higher interest rates are unlikely to be the precipitating factor in the next recession, what about financial excesses? Looking around, one can certainly see areas with high asset prices and high leverage, such as in private-equity deals. The International Monetary Fund has warned of substantial corporate financial distress if growth slows significantly. Yet, it is hard to see widespread problems materializing if interest rates stay low and liquidity remains plentiful.

Of course, at some point, growth will slow or interest rates will rise, and liquidity will tighten. Whenever that happens, financial assets will suffer significant price declines, and corporations will find it hard to roll over debt. Moreover, the longer the environment of easy financing lasts, the greater the number of sectors with excesses will be, and the higher the risk that these will precipitate a downturn. But with monetary conditions remaining accommodative, it seems more likely for now that financial excesses will exacerbate the eventual downturn and slow the recovery, rather than being the cause of the economic winter.

The question, then, is what might disrupt consumption, which currently is holding up growth. One answer is layoffs. And what could precipitate those? A further escalation of the trade war – for example, if the US were to levy tariffs on European and Japanese automobiles – could do so. As matters stand, it is unlikely that we will get a comprehensive Sino-American trade deal during the remainder of this US administration’s term. There is little trust between the Chinese and the Americans, and it is hard to see China agreeing to the intrusive monitoring that would be necessary to verify some of the actions the US wants it to take. Moreover, the possibility that a deal could strengthen Trump’s prospects for re-election in 2020 must also increasingly weigh on negotiations. Do the Chinese want to keep dealing with Trump, or would they prefer a Democrat (who may be no less protectionist)? Either way, the uncertainty over trade will almost certainly continue to dampen investment – and thus growth – for the foreseeable future.

A second possible precipitating factor is geopolitical risk. We saw an example of this in September, when Saudi Arabia’s oil facilities were struck in a nighttime drone attack. The apparent vulnerability of Saudi oil production introduces a new element of uncertainty into the global outlook. Iran, increasingly cornered, appears to be sending a clear warning: if it goes down, it will take Saudi Arabia and the United Arab Emirates with it. Iranian government hardliners have been strengthened by the Trump administration’s withdrawal from the 2015 nuclear deal and emboldened by recent unanswered acts of aggression. And while the Saudis have since indicated a willingness to negotiate with Iran, the risks of a regional conflagration will remain heightened.

A spike in the price of oil could tip the global economy into recession. It certainly would reduce consumers’ disposable income and weaken sentiment, further dampening investment. And the possible inflationary consequences would leave central banks with little room for more accommodation.

While recessions are, by their very nature, unpredictable, the greatest near-term threat to the economy is not rising interest rates or various financial excesses, but, instead, unforeseen actions in areas like trade or geopolitics. If the world had fewer wannabe strongmen, the global economy would be much stronger than it is. Unfortunately, most of today’s authoritarian leaders are there because voters put them there. But that is a discussion for another day.