From: JP Morgan Chase
By: Jim Glassman
Date: January 10, 2018
Given that the current recovery is one of the longest running in recent history, some are worried about an impending downturn. However, key indicators suggest the economy is still somewhere in the middle of the business cycle.
The current recovery is wrapping up its ninth year, rivaling only the 1990s recovery as the longest-running expansion in recorded history. Eventually, the current business cycle will peak and the economy will enter a new recession. However, key indicators, such as low inflation and a strong labor market, suggest that there is little reason to worry about a new economic downturn anytime soon. In fact, above-trend growth could continue for several years before the present expansion draws to a close.
What Caused Recessions in the Past?
Historically, recessions have been sparked by major imbalances in the economy. Every political setback and stock market hiccup in recent years has been met with unease—from Brexit to the US federal debt downgrade to the global energy glut, each new headwind has been treated as the first symptom of a downturn. But despite these events gaining media attention, there doesn’t seem to be any sign of trouble brewing in asset markets today.
The last three recessions have occurred after an asset bubble grew and burst. In 2008, a sharp correction in real estate prices erased tremendous household wealth and pushed the economy into a deep contraction. But while home prices have seen strong gains recently, real estate values are still in alignment with historical trends. Prices are consistent with past periods of economic strength, with no obvious replay of the speculative bubble that marked the tail end of the last business cycle.
Other major asset markets are also in alignment with historical norms. Stocks are valued highly, but the market’s price-earnings ratio is far from unprecedented. Bond markets are similarly well-balanced, reflecting a rationally optimistic outlook among investors.
Low inflation is the strongest indicator that the business cycle still has room to expand. As long as price pressures remain subdued, it’s likely the economy is operating below its potential and still has the capacity for growth. Eventually, aggregate demand will outstrip the nation’s productive potential, sending prices spiraling. But with inflation still resting below the Federal Reserve’s 2 percent target, this business cycle looks far from complete.
The current inflation rate also allows the Fed to withdraw its accommodative monetary policy gradually. With prices rising slowly, the Fed can keep short-term interest rates at historically low levels, encouraging capital investment and consumer spending. The Fed’s forecasts for rate hikes and balance sheet normalization show a near-consensus view among policymakers that the economy is still midway through the business cycle.
What About the Labor Market?
At first glance, the job market shows many late-cycle features. The headline unemployment rate is lower than it was at the peak of the last business cycle—and within three basis points of its multi-decade low in April 2000 (Opens Overlay). If a tightening labor market forces businesses to cut back on expansions requiring new workers, the pace of economic growth could slow.
However, the labor market likely still contains hidden slack. The labor participation rate is well below historical norms, implying that approximately 1.5 million workforce dropouts have yet to return to the job hunt. As they do, the market could continue creating jobs at an above-trend pace for some time before it truly begins to tighten.
Job creation is only half of the story. Worker productivity growth throughout the recovery has been sluggish, despite a rapid pace of technological advancement. As the job market tightens, we should expect businesses to invest in productivity-enhancing technologies and worker training. This could allow for a growth surge that transcends demographic limitations.
Estimating the Economy’s Potential
The economy’s true potential is unknowable, but as long as its total output is below its full potential capacity, there is room for above-trend growth. Extrapolating from the peak of the past business cycle, models show that the economy may still be operating as far as 2 percent below its true potential. If this is true, the current rate of growth could be maintained for several years before the output gap is fully closed.
Critics of fiscal and monetary stimulus often claim that any attempt to spur growth will simply hasten the next recession. But if the business cycle is still in its middle stages, fears of an overheating economy are misplaced. Key indicators show that the economy is still midcycle with plenty of room for growth ahead.
Economic Commentary Disclaimer
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