We continue to believe that both the global economy and the U.S. economy remain in a long expansion despite a variety of stresses, including profit challenges, high debt levels, low potential growth and global trade tensions. However, the global economic expansion can be prolonged precisely because it is sluggish. The sluggish pace of global growth restrains core inflation and thus permits persistently easy monetary policy. We think that the next recession will be triggered the old fashioned way — by aggressive central bank tightening in response to excessive inflation. If that is to be the cause, it's unlikely to occur any time soon. Because the global economy has not been growing at an above-trend rate, global supply remains ample and tends to dampen upward pressures on core inflation.
Brexit was one of several recent setbacks for the global trade system. The rhetoric in the U.S. presidential election has focused on the costs rather than the benefits of global trade. As a result, we believe that the prospects of completing either the European trade deal or the Asian trade deal anytime soon are poor. We do expect the U.K. to implement an exit from the European Union over the next several years, which is likely to be a contentious process. The global economy was already flooded with excess financial liquidity, which helped limit financial contagion following the Brexit vote. Now there are market expectations for an even lower path of policy rates in many countries. This should help dampen economic contagion from the Brexit. We do not believe that Brexit will trigger a global recession. Nonetheless, there is likely to be a recession in the U.K., a somewhat slower growth rate in Europe and a moderate global-growth slowdown.
U.S. Expansion Persists
The current economic expansion in the U.S. has run for seven years (or 85 months, from June 2009 to July 2016). It has lasted much longer than the average postwar expansion of 58 months, as documented by the Business Cycle Dating Committee of the National Bureau of Economic Research. Given our long-term theme of “Eight-Year Economic Expansion," we expect the current expansion to persist for at least another year (and probably well beyond that).
We do not agree with the view that because the expansion has been so prolonged, the U.S. is therefore due for a cyclical recession sometime soon. Rather, we believe that it is the stage of the monetary policy cycle that is most critical. We divide the monetary policy cycle into five stages: aggressively stimulative, stimulative, neutral, restrictive and aggressively restrictive. Monetary policy is in the process of moving gradually from stimulative to neutral and is nowhere near the restrictive stance sufficient to trigger a recession.
A Gradual Rise in Inflation
We do expect a very gradual, upward drift in global and U.S. core inflation, based on its current slow pace in response to easy monetary policy and continued economic expansion. As long as there is a gradual, rather than an abrupt, rise in U. S. core inflation, monetary policy should remain easy enough to support continued expansion. Eventually, restrictive monetary policy may coincide with a major hangover from the artificial scarcity of sovereign bonds created by central bank quantitative easing, but that is a problem for some future year.
Slow Pace of Tightening From the Federal Reserve
After seven years near a zero policy rate, the Federal Reserve has begun to raise the federal funds rate. However, this does not represent forced tightening in response to excessive inflation. Instead, such actions are optional, voluntary moves as excess supply in the labor markets has been reduced. The Federal Reserve retains the option to halt or even reverse these moves should it become necessary.
We believe the markets went too far in discounting the odds of future rate hikes over the next several years. Both cyclical dynamics and minimum-wage increases are likely to generate an upward drift in wage inflation, which should help create a multiyear pattern of rate hikes, beginning at the end of 2016 or early 2017. A shift to more expansionary fiscal policy after the election could help motivate a return to gradual hikes in the federal funds rate.
There are several reasons why Federal Reserve tightening is likely to be gradual rather than rapid over the next several years. The expansion has been slow and the labor market has only recently begun to approach full employment. Core inflation is still below target and inflation expectations are low. Central banks prefer that inflation expectations remain “well-anchored" and tend to be hesitant to tighten policy too fast when inflation expectations are at the low end of a multi-year range.
In addition, Federal Reserve actions, and guidance about future actions, tend to impact the dollar in a way that intensifies the impact of Fed policy changes. On balance, tightening relative to other central banks tends to strengthen the dollar, restraining both competitiveness and inflation pressures. We expect a U-shaped pattern for the dollar this year, with the highs at the beginning and end of the year.
Financial Regulation Dampens Economic Demand
The monetary accelerator of easy Fed policy has been partially offset by the regulatory brake of restrictive financial regulation. Since financial regulation continues to tighten even as the U.S. economy begins the eighth year of economic expansion, the transmission of easy monetary policy to economic demand continues to be somewhat dampened. Given the regulatory restraints on financial intermediaries, credit availability has not loosened as much for users of intermediated credit, such as small and medium-sized corporations, as it has for forms of large-scale financial engineering, which can directly access the securities market.
Low Potential Growth Rate
Some stresses are beginning to appear in the U.S. economy. The unemployment rate has been cut in half by an economic growth rate close to only 2% in this economic expansion. This implies that the potential growth rate of the U.S. economy is currently quite low. We believe that one cause is the growth-hostile economic drag from successive rounds of financial and non-financial regulation that have been introduced into many parts of the U.S. economy. The American economy has transitioned to a form of bureaucratic capitalism, as decision-making power has shifted from the private sector to the public sector. The risks of severe financial crisis have dropped, but so has the trend growth rate of the economy.
Slower Growth in Employment
Last month's labor report was quite weak. We do not regard this as a recessionary signal. However, we do believe that the moving average of monthly payroll gains is shifting down to a somewhat slower growth rate due to a deceleration in both labor-demand growth and labor-supply growth. Weak corporate profits have intensified incentives for companies to restrain the pace of hiring while a labor market closer to full employment is making it more challenging for employers to find the skills they are seeking.
For now, we expect a gradual deceleration in the pace of monthly average payroll gains, somewhat below its prior pace. However, despite slower growth in employment, growth in incomes should be aided by a gradual upward shift in wage inflation. This wage inflation should make it somewhat challenging for corporations to maintain their profit margins unless they are restrained in their hiring, which we expect they will be.
Expect Fiscal Stimulus in Early 2017
The economic policy impact of the coming presidential election is somewhat uncertain, because what can be passed through Congress is often more limited than what the candidates propose. However, there are some similarities. Neither candidate is focused on major entitlement reform. Fiscal restraint is not a major theme in this election cycle. Whoever wins the election, we would expect some fiscal stimulus in early 2017, financed in part by the repatriation of the overseas cash of U.S. corporations. While this should increase the tax revenues of the federal government, it should also increase the financial liquidity of major U.S. multinational corporations as they gain access to much of the cash that has been trapped overseas.
There are a variety of stresses that have restrained global growth to a slightly below-trend pace, including:
However, a key implication of the multiyear period of slightly below-trend global growth is that a rapid upsurge in core inflation is unlikely to occur in any major country. With core inflation likely to drift higher at only a gradual pace, global monetary policy can remain easy, with some central banks easing further and a few tightening at a gradual and tentative pace. Low core inflation should permit global monetary policy to remain accommodative enough to sustain a prolonged global economic expansion.