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The economy at mid-expansion: Look toward the next recession

Comerica Bank Chief Economist Robert Dye says it’s time to take a different perspective on the economy. Short story: “We need to get past the view that the economy is just now recovering. We’re actually in the middle of the expansion.”

2015-10-15

Comerica Bank Chief Economist Robert Dye says it’s time to take a different perspective on the economy. Short story: “We need to get past the view that the economy is just now recovering. We’re actually in the middle of the expansion.”

Dye was presented with the Lawrence R. Klein Award for Blue Chip Forecast Accuracy on October 14 in New York City. Presented annually by the W. P. Carey School of Business, the award is one of the longest-standing and best-known in economics. Dye was recognized as the most accurate U.S. economic forecaster among the nation's top economists for the years 2011 to 2014.

Dye explained that the early part of this expansion was the post-recession period of 2010-2013. The mid-cycle — where we are now — is the transitional period, which he expects to last until about 2016. Then will come the late cycle economy, which will last until the next down-cycle — “perhaps not until 2018 or 2019 if we are lucky.”

“It is now appropriate to look over the horizon and ask where the next recession might come from and what will be the condition of our businesses, our households and the rest of the world when we get to that next down-cycle,” Dye explained. Doing just that, Dye shared five headwinds and five tailwinds that will hinder and help the economy in the years to come.

Headwinds

As the U.S. Federal Reserve Bank weans the economy off its “extraordinary” monetary policy, Dye expects more volatility of the kind the stock and bond markets have been experiencing. The Dow Jones Industrial Average fell almost 8 percent in the third quarter. 10-year U.S. Treasury note yields, which had looked set to break above 2.5 percent, actually sunk lower.

Dye credits the former Fed chairman Ben Bernanke for “being innovative” and “trying many different tactics in a time of crisis and chaos.” But as time wears on, the benefits of extraordinary monetary policy are diminishing and the costs are increasing, he said. “Zero interest rate policy has caused investors to reach for yield. It has also put pressure on pension funds and other parts of the financial system. It has reduced returns for retirees dependent on their investments in bonds.”

“The market is used to having the Fed backstop the economy, but that’s not a normal state of affairs,” Dye explained. “My concern is that we’ve become complacent about where risks are accumulating. Fed policy is essentially a price control on the cost of capital, and price controls cause distortions.”

It is particularly unusual, Dye said, to still have zero interest rate policy in the middle of an expansion. But that’s not likely to change quickly. “We may not see normal interest rates — around a 3.5 percent Fed funds rate — at all in this business cycle because we’re already heading into a late-cycle economy and the Fed is most likely to increase interest rates very slowly.”

But there’s a danger in that. “As long as interest rates are unusually low, it reinforces ongoing distortions to the global economy,” he said.

A second headwind is the U.S. dollar, which has strengthened significantly — up 14 percent between August 2014 and August 2015. Exchange rates have been made more volatile by what Dye referred to as “desynchronized global monetary policy.” While the U.S. central bank has tapered its quantitative easing and is talking in earnest about raising interest rates, “extraordinary” monetary policy is in full swing in other countries.

A strong dollar is good for American consumers buying goods from other countries, but it’s a problem for American producers. “The strengthening of the U.S. dollar has been a drag on U.S. manufacturing and exports,” Dye explained. Real exports of U.S. goods grew less than 1 percent between the second quarter of 2014 and the second quarter of 2015.

The third headwind comes in the form of falling oil prices. “The energy sector received a major blow in 2015,” Dye explained. “West Texas Intermediate crude oil prices dropped from the June 2014 high of $105.78 per barrel, down to $42.55 in August 2015 — a 60 percent fall.” One result: The U.S. has lost a net 104,000 jobs in the resources and mining sector thus far in 2015.

Behind the 60 percent fall in oil prices is what Dye called an undeniable revolution. “There has been a revolution in U.S. producers’ ability to produce significantly more oil, and a revolution in OPEC’s response. Saudi Arabia shifted its stance from price stabilizing to defending market share, which has meant allowing the price of oil to plummet.”

The fourth headwind brings with it global risks. Extraordinary monetary policy, a strengthening dollar and falling oil prices have all contributed to market volatility this year. Another source of volatility is China. “It looks like China’s economic growth will fall below the so-called ‘soft landing’ of around 7 percent,” Dye explained. “The effects of that weakness will spill over to the rest of Asia — and potentially, the rest of the world.”

In addition to an economy that seems to be cooling more than anyone predicted, China’s consumers are increasingly leveraged. The combination is risky. And it plays out in Japan too, where growth has been stagnant and the debt-to-GDP ratio (a measure of leverage) is a very high 400 percent. Japan and China are huge global economies, and their weakness will affect the rest of the world, Dye said.

Finally, the economy will be impacted by a slowdown in the manufacturing sector. Manufacturing led the U.S. economy out of the Great Recession, but has started to cool, Dye said. “Auto sales, for example, are still strong but they’re at or near their cyclical peak. The tailwind we’ll get from auto sales is in the rearview mirror.”

Tailwinds

Extraordinary monetary policy, a strengthening dollar, falling oil prices, global risks and slowing manufacturing — all headwinds — will affect the shape of the U.S. economy for the rest of this expansion and into the next downturn. But there are tailwinds, too: consumer spending, a housing rebound and a strengthening labor market.

Dye sees two significant changes affecting consumer spending. One is a return to more appropriate levels of household debt. “We’re at a turning point. Prior to the Great Recession, American consumers were highly leveraged — high debt relative to income. During the recession, consumers got deleveraged whether they wanted to or not. Now they’re increasing their debt relative to income, but to appropriate levels. That means they can buy houses, cars, appliances — big purchases that boost total consumer spending.”

The other significant change Dye sees is a return to more appropriate levels of saving. “There’s a relationship between the savings rate and housing prices,” he explained. “The savings rate had been declining before the Great Recession then it jumped during the recession. When households save more, they spend less. But as housing prices rise, household wealth increases (for homeowners, anyway), so households don’t need to save as much.”

That’s a good thing, Dye explained, because households were “over-saving” during the Great Recession — and, as a result, under-spending. “When consumers take on more debt in an appropriate way and aren’t forced to over-save, that puts them in a good place to support economic growth moving forward.”

For most of the last decade, economists have focused more on baby boomers than any other generation. That’s shifting — now it’s all about millenials. Specifically, about how different millenials are in their spending habits, their employment expectations and their living arrangements. But Dye said that as millenials get older and start to have families, they might end up looking a lot like previous generations.

That would mean, in part, demand for single-family housing. “Multi-family housing was hot after the Great Recession, in part because people couldn’t buy homes, and in part because of urbanization. But going forward we’ll see more emphasis on single-family housing,” Dye said.

Dye forecasts that the unemployment rate will be below 5 percent by early next year. “We’ve seen the reabsorption of people who were put out of work during the Great Recession,” he explained. “Now labor markets are tightening.”

And tightening labor markets puts upward pressure on wages, which feeds into inflation. “The near-zero inflation we’ve been experiencing will prove to be a transient phenomenon,” Dye said. “As oil prices stabilize, housing prices rise and wages rise, we’ll see a return to inflation.”

Bottom line

Together, headwinds (extraordinary monetary policy, a strengthening dollar, falling oil prices, global risks and slowing manufacturing) and tailwinds (consumer spending, a housing rebound and a strengthening labor market) will shape the rest of the current expansion, and the next contraction.

It isn’t fun to look ahead to the next recession, but Dye sees the potential for a silver lining there. “It’s easier to imagine the next recession being shallower. It might even be a confidence boost — to realize that we can go through a moderate recession that we don’t have to repeat the hard fall of 2008–09.”

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