In The Economic Sweet Spot: Why A Downturn Could Be Years Away
As seen on Forbes.com
Many people are wondering where we are in the economic cycle. After strong gains in the equity markets in 2017, the “gambler’s fallacy” is causing investors to worry that a losing streak will erode their gains. Yet given its unique nature, if the economy were a baseball game, this cycle should only be in the seventh inning and could have potential for extra innings.
The normal cycle
Early in a normal cycle, the economy begins to revive and business sales growth accelerates even as the overall level of activity remains depressed. Although sales start to improve, businesses worry that the improvement will not last. Fortunately, since firms typically have spare capacity, the lack of confidence does little to block renewed growth.
As sales continue to improve, confidence in the recovery increases and firms start to hire more workers to expand operations, bringing down the unemployment rate. Improvement in the labor markets rebuilds the public’s confidence in the economy, which also helps to sustain economic growth. Economic news is usually positive at this stage, and increased confidence makes even neutral reports seem more optimistic. Improved confidence also encourages consumers and businesses to spend more freely. The public’s confidence helps give economic growth a self-sustaining bias.
The beginning of the end for most cycles comes when inflation escalates. Wages rise as labor becomes scarce, and other prices increase as supplies tighten. To combat inflation, the Federal Reserve slows economic demand by raising interest rates. The problem is that rate hikes typically do not affect the economy for about a year after implementation, making it difficult for the Fed to reduce economic growth without overshooting the mark. As a result, rate hikes often lead to recessions, which in turn are usually accompanied by major equity price declines.
What makes this cycle different?
An intensely competitive business climate has helped keep inflation weaker than it has been in the past. Slow sales growth and low capacity utilization have robbed businesses of pricing power. Thus, although the demand for consumer goods has risen, prices have not—remarkably, the price of consumer goods with longer useful lives (i.e., durable goods) has actually fallen over the last year.
Weak sales growth and intensive pricing competition have also made businesses much more cautious about expanding operations. The reluctance to expand, along with weak labor productivity growth, may be part of the reason wages have not risen more rapidly as the economy has neared full employment.
Where we go from here
At this point, we have entered the “sweet spot” of the economic cycle: where the public has become confident of economic growth, but before inflation rises enough to initiate the descent toward recession.
The U.S. economy grew 2.5 percent through the third quarter of 2017, just a little faster than it has over this entire cycle. Although headline consumer inflation has picked up this year, some of the critical inflation statistics remain well below the Fed’s longer-term target. At that pace of economic growth, this cycle should have an extended horizon. Even 2.5 percent growth should eventually produce higher inflation, through shortages of labor or other critical inputs, but not as quickly as faster growth would.
The fact that many economic forecasters are calling for accelerating growth in 2018 could therefore be significant. Estimates of 3 percent are not uncommon, especially if the new tax bill spurs faster growth. That could shorten the time to higher inflation and the end of the cycle.
Faster growth, though, would require that we watch the data more closely. Rising wage increases should probably precede broader inflation, which should lead to rising rates before the economy actually begins to slow. As the sequence falls into place, increased caution will be warranted. But until that happens, we need to recognize that the current sweet spot may last longer than it has in the past. Bear in mind, too, that even if faster growth causes higher inflation, it should not bring the cycle to an immediate end. Given the normal lag time for rising rates to affect the economy, economic growth should remain positive for about 12 months.
Psychologists tell us we become uncomfortable when a winning streak continues for an extended time, and so the “gambler’s fallacy” often urges us to abandon our investments too quickly in the economic sweet spot. If growth remains slow enough to put off rising inflation, we could have another two years or so before the next downturn, which could provide conditions that would make investors glad they remained invested.
About Bruce McCain
Bruce McCain is the Chief Investment Strategist for Key Private Bank, where he monitors the economy and the financial markets and serves as part of the team that formulates investment strategies for clients. He supplies frequent insights to media throughout the region and around the country. His comments and interviews have been featured in such publications as The New York Times, The Wall Street Journal, Investor’s Business Daily, and Business Week, as well as on television outlets such as CNBC and Bloomberg TV. He is also a regular source for wire services such as the Associated Press and Reuters and is a Contributor on Forbes.com. Bruce joined a predecessor of Key in 1987, after spending six years on the business faculty of the University of Iowa’s Henry B. Tippie College of Business. Bruce earned a PhD in Business Administration from the University of California at Berkeley, and undergraduate degrees in Psychology and Accounting from Boise State University.