If a recession comes anytime soon, the US government will not have the tools to fight it. The White House and Congress will once again prove inept at deploying fiscal policy as a counter-cyclical stabilizer; and the Fed will not have enough room to provide adequate stimulus through interest-rate cuts.
Running the economy hot has produced some good numbers in the short run, but warning signs are beginning to accumulate. Although there is no natural life-span for a business cycle, this one has already been the longest on record, measured the previous peak of December 2007. It is only prudent to give some thought to our preparedness for the next recession — or our lack of it.
Let’s start with the monetary side. The Fed’s primary tool for fighting recessions is to cut its key interest rate, the federal funds rate, in order to encourage lending and maintain liquidity of the banking system. However, for that tool to work well, the rate has to be high enough before the downturn starts to make room for significant cuts.
The following chart, in which gray bars show recessions, allows us to compare the present situation with business cycles of the past. For example, in late 2000, as the dot-com boom began to wind down, the fed funds rate stood at 6.5 percent. Over the next year, the Fed cut the rate by four and a half points, helping to keep the 2001 recession short and shallow. That still left room to cut another point over the next two years, speeding the recovery.
By the summer of 2007, when it was becoming hard to ignore the growing weakness of the housing sector, the fed funds rate had risen to 5.25 percent. Between July 2007 and December 2008, the Fed cut it as close to zero as was technically possible. This time, even a 5-percentage-point rate cut was not enough to avoid a serious slump.
In both 2001 and 2007, the Fed was able to begin cutting the fed funds rate based on early indications of trouble, and still have room for maneuver. Today’s situation is not as favorable. If a strong expansion continues through 2019, the rate may rise a bit higher than its current 2.4 percent, but if a recession were to come sooner, the Fed would have far less countercyclical ammunition than it did at the two previous cyclical peaks.
Let’s turn now to fiscal policy. As the next chart shows, the federal deficit normally moves toward surplus as the business cycle approaches its peak. When a recession begins, or seems about to begin, having the deficit under control creates “fiscal space” that makes it easier to use tax cuts and spending increases to moderate the downturn and boost the subsequent recovery.
This time, however, the budget began moving toward deficit already in 2016. The turning point came with a package of spending increases and tax cuts, designed to keep the government running through the 2016 elections, that was passed in December 2015. That was followed by an even larger tax cut, not matched by spending cuts, at the end of 2017. Although final numbers for 2018 are not yet available, the deficit for 2018 (shown by the extension of the line at the far right) is estimated to have been 3.9 percent of GDP. That makes the downturn earlier and the pre-recession deficit larger than in any other business cycle since World War II.
Under these conditions If a recession were to come any time soon, the deficit will quickly eclipse the 10 percent mark that it approached at the bottom of the Great Recession. Even if we accept the technical feasibility of large-scale stimulus under those conditions, it would take a Congress with a lot more political courage than the one we have now to pass a robust countercyclical package of tax cuts and spending increases under those conditions.
The bottom line: DeLong is right. We are not ready for the next recession.
Previously posted at Medium.com