This appeared in the Times of India on 13 August 2024 (link).
Over the past two years, consensus on the US economy had shifted from anticipating a ‘hard landing’ (that is, a recession) to a ‘soft landing’: That inflation would be contained without much of a growth sacrifice. Some observers hailed this as ‘immaculate disinflation’.
This has been challenged by recent economic data. Despite a slight fall, unemployment claims are well above the lows of Jan, and new job openings have slowed. In July, the unemployment ratio rose to 4.3%, the highest in 3 years, and the ISM manufacturing PMI, an important bellwether, fell to a nine-month-low, to a level rarely seen outside recessions.
Recession fears are back: Google Trends shows searches for ‘recession’ in the US are up nine times since mid-July to the highest in two years. A large part of the jump in stock-market volatility can be attributed to other factors, like some unwinding of the Yen carry trade, but recession fears have played a major role. Market expectations of rate cuts by the US Fed have risen significantly, as many believe these will be necessary to moderate the economic slowdown.
In particular, July’s labour data triggered the ‘Sahm Rule’. Discovered by Claudia Sahm, a former Fed economist, this rule states that a recession is probably underway if the average unemployment rate over the past three months has risen by half a percent from its low point over the previous twelve months.
The underlying logic is simple – when unemployment rises by this quantum, it triggers a self-reinforcing cycle; it hurts incomes and therefore consumption, triggering more lay-offs, and so on. Over the past half-century, this rule would have correctly predicted all US recessions.
At first glance, such fears seem premature. The US economy is slowing but is far from recessionary. It is the only large economy where GDP is above its pre-pandemic path. Nowcast estimates for this quarter’s GDP growth in the US economy were recently raised to 2.9%, from 2.6% earlier. Consumption remains steady, wage growth on average is above inflation, home prices are still rising, and lay-offs have not started yet.
Even after the increase in July, the unemployment ratio is still below ‘normal’. Further, a large part of the rise in unemployment has been due to more people joining the workforce (including due to a rise in immigration), with the labour force participation rate the highest this century.
But much of that is backward-looking, and financial markets tend to price in recessions or recoveries several months before they appear. Let alone ‘nowcast’ estimates, built on a relatively narrow set of indicators, even reported quarterly GDP growth can see significant revisions. The first estimate for the March 2001 quarter, for example, showed 2.0% growth, but the final one a 1.3% decline, showing that it was the first quarter of a recession.
Such large revisions are not normal, but some cooling of the economy is to be expected. In our view, a significant part of the growth surprise over the past two years was due to an expansion in the federal fiscal deficit. An increase in fiscal deficit boosts growth, a falling fiscal deficit is a drag on growth, and high but unchanged deficits have no impact on growth.
The fiscal impulse in the US was a strong 5% of GDP around this time last year. As the deficit could not rise further, this impulse has slowed sharply to nearly zero this quarter and is likely to be in negative territory in the next few months.
Over the past two years, the pain from higher interest rates in the US had been offset by the rise in fiscal deficits. Even if the deficit does not shrink to sustainable levels immediately, the absence of a positive impulse is likely to show up in weaker growth.
For example, a guinea pig (economy) that gets a growth inhibiting injection (higher interest rates) but also a growth enhancing injection (higher fiscal deficit) may not see a change in growth. But when growth boosters are stopped, its growth would slow down. The Fed is now likely to start cutting interest rates, but a complete rate normalization will take several quarters at least, and the impact of cuts appears with long and variable lags.
Separately, as US fiscal deficits were “pro-cyclical” (high deficits when growth was already strong), slowing growth would push deficits higher, and thus, despite the Federal Reserve’s rate cuts, yields on US government bonds and the cost of borrowing may not fall as much.
In our view, a growth slowdown is likely, but it is too early to call for a precipitous decline. The slowdown should be orderly if monetary easing can reduce the risk of accidents in financial markets. Volatility in the markets, though, is likely to remain elevated, as growth expectations are recalibrated, and upgrades to US growth forecasts are replaced by downgrades.
A US slowdown would affect the Indian economy too, through weaker exports. However, if there are no accidents in financial markets, easier global financial conditions, as the Federal Reserve cuts rates and potentially restarts quantitative easing, should provide Indian policymakers room to ease policy. This is necessary because despite strong growth, India’s economy is still more than a year behind where it would have been if not for the pandemic.