As the US celebrated Thanksgiving last week, many Americans must have been giving thanks for the current strength of the US economy, which is growing at about 3pc, while unemployment stands at a 49-year low. Moreover, the labour market is still tightening and wage growth is picking up. Unsurprisingly, consumer spending has been buoyant and consumer confidence is strong. What’s not to like?
While this happy state will probably be sustained for a while yet, underneath the surface you can detect signs of trouble ahead. Recent weakness in the stock market has several underlying causes, and growing anxiety that the good times cannot last is one of them.
The strength of consumer spending this year owes a good deal to President Donald Trump’s tax cuts, while other parts of the economy have been boosted by the programme of increased government spending. But the boost from these factors will soon fade. And after the recent midterm elections, it is unlikely that President Trump will be able to launch a second stage of his tax-cutting programme.
Meanwhile, the scale of this fiscal expansion has ensured that, despite the strong economy, the federal government deficit is worryingly high. It is currently 3.8pc of GDP but it will rise to about 5pc in a few years. (The UK’s deficit should be just over 1pc this year.) Moreover, the ratio of federal debt to GDP looks set to rise relentlessly to almost 100pc within 10 years.
But the main focus of concern should be interest rates. Official rates have risen by 2pc and all the signs are that the Federal Reserve will raise them again in December. It may well increase them twice more next year, taking the Fed Funds Rate (roughly the equivalent of our Bank Rate) to a peak of 2.75pc-3pc.
It is easy to be lulled into a false sense of security by the low level of these interest rates, even after the Fed’s anticipated further action. Instead, you should pay attention to the increase in rates. Over the last two years, real (ie inflation-adjusted) two-year Treasury bond yields have increased by 2.5pc. Increases of this magnitude were also experienced in the late Eighties, the late Nineties and the mid-Noughties. In each case a recession ensued.
You can already see some signs of weakening in those parts of the US economy that are particularly interest rate-sensitive. Home sales have recently softened and capital investment spending by companies has weakened. Spending on new cars, by contrast, has recently picked up. But this is almost certainly because of hurricanes Florence and Michael, which destroyed many vehicles.
By the end of next year the rate of economic growth should be falling back quite markedly, and in 2020 the growth rate should be a good deal lower than it is currently. As things stand, I wouldn’t forecast an outright recession, not least because there don’t appear to be significant imbalances in the economy to trigger a major adjustment. But I wouldn’t rule one out. Note that, even without a recession, if my prognosis is correct, the US economy will be performing badly in the run-up to the next presidential election in November 2020.
Does this economic outlook mean the Fed is making a mistake in its interest-rate policy? Not necessarily. It is all a matter of balancing the risk of higher inflation against the risk of weaker growth. As it happens, I suspect that US inflation is already stabilising and that in the next couple of years it will fall back a bit from the current 2.5pc. But the Fed cannot rely on this. With the labour market tight and the rate of wage increase rising, and in the context of interest rates being low by historical standards, the Fed seems bound to take the precaution of moving rates up in order to head off the inflationary danger.
Moreover, it will want to restore some semblance of normality in money markets, thereby minimising the financial and economic distortions that are already building up.
If the US economy does slow markedly, does this spell danger for the rest of us? It would certainly make things more difficult. In the past, the US economy and other leading economies have typically moved in sync. But that has often been because most countries in the world have been affected by the same factors, such as major increases in oil prices.
In fact, there have been a number of notable occasions in the past when a marked slowdown in the US economy has not been accompanied by an equivalent slowdown in the rest of the world. For instance, in 1969-70, US growth dropped from about 5pc to almost zero while in the rest of the world growth was unchanged.
For us here in the UK, we will, of course, suffer some ill effects from a US slowdown in 2019/20. But if and when we have accomplished Brexit successfully, uncertainty will be dispelled and confidence will return. We may be able to weather the storm blowing in from the US pretty well compared to other large economies.
By contrast, the eurozone will suffer the pain without any beneficial offsetting effects. It is notable that the recent reasonable pickup in eurozone growth is fizzling out. Growth this year is likely to be just under 2pc. If a US slowdown, coinciding with a slowdown in China, produced a slower world economy, never mind a serious downturn, then European growth rates would dip.
That does not matter much when, as in the case of Germany, you are doing pretty well. But when, like Italy, you have spent 20 years in near-stagnation and are currently on the brink of recession even when the world economy is growing nicely, a global slowdown could be the straw that breaks the camel’s back.
Assuming, that is, that this Italian camel’s back has not been broken already.
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