Three policy icebergs that could sink our economic ship

Three policy icebergs that could sink our economic ship
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In early 2017, Oxford Economics started warning its clients about the risks of a U.S. economic slowdown in 2020. The reasoning was that the anticipated (but not yet delivered) fiscal stimulus program would temporarily boost growth in 2018 and early 2019, but its effects would gradually wane.

At the same time, tighter monetary policy and a more protectionist stance would weigh on growth and deter private-sector activity, leading to an economic slowdown.


Fast forward to October 2018. It has now become somewhat fashionable to call a recession in 2020. Case in point, the renowned National Association for Business Economics (NABE) survey of over 50 professional forecasters shows two-thirds of respondents expecting a recession before the end of 2020 and 56 percent expecting a recession in 2020.

While these statistics sound quite worrisome, they should be understood within the context of a strong U.S. economy.

The U.S. is currently in its second-longest expansion on record with the economy having grown for more than 110 consecutive months. Real GDP growth clocked in at 2.9 percent, year on year (y/y), in the second quarter, and early estimates for the third quarter point to growth reaching 3.0 percent y/y for the first time since 2015.

Assuming GDP growth doesn’t collapse in the final quarter of the year, the U.S. economy may even register its strongest annual performance since 2005.

With consumer spending trending at 3 percent, supported by household confidence near an 18-year high and the labor market still adding close to 200,000 jobs monthly, one could easily foresee rosier days ahead instead of a recession.

These aspirations would be further comforted by the fact that business investment is recording its strongest performance since 2014.

But if all is well, then why are most forecasters sounding the recession alarm for 2020, and are they justified in doing so? This is where a look at vulnerabilities and risks become essential.

Indeed, while the economy is strong, it will face a trifecta of policy risks in the coming months: rising protectionism, tightening monetary policy and diminishing fiscal tailwinds.

On the trade front, the administration continues to vehiculate the myths that trade deficits are inherently bad, that they are caused by unfair trade practices and that protectionism is the solution to these deficits. Pursuant to these views, President TrumpDonald TrumpKinzinger welcomes baby boy Tennessee lawmaker presents self-defense bill in 'honor' of Kyle Rittenhouse Five things to know about the New York AG's pursuit of Trump MORE has imposed successive waves of tariffs on our main trading partners.

China has been the primary target of these tariffs with the implementation of 10-percent tariffs on $200 billion of imports from the Asian giant as of Sep. 24 (on top of the existing 25-percent tariffs on $50 billion of imports).

With the U.S. administration announcing that China tariffs would rise to 25 percent on Jan. 1 and cover all imports from China in the case of retaliation (which happened on Sep. 24), it appears further escalation is likely.

Indeed, the recent announcement of a refurbished North American Free Trade Agreement (NAFTA) — the U.S.-Mexico-Canada Agreement — may comfort the administration in believing that its hawkish trade tactics yield results.

The main trade risk therefore lies in the possibility of an all-out trade war between the world’s two largest economies. The consequence of such a conflict would be damaging not only to the two protagonists, but also to the rest of the world.

Macroeconomic simulations point to potential GDP losses approaching 0.5 percent for the U.S. and potentially more for China.

Meanwhile, at home, prices and input costs have been rising with consumer price inflation hovering around the Fed’s 2-percent inflation target, and indications that core inflationary pressure may yet rise further as the economy continues to grow strongly and import tariffs filter through.

While this steady rise in prices doesn’t portend to spiraling inflation (in part thanks to anchored inflation expectations), it does translate into reduced disposable income, and thus reduced marginal spending capacity for households — a potential restraint on the main engine of economic growth.

Rising inflation comes at a time when the Fed has appeared more hawkish. In recent speeches and statements, Federal Reserve Chairman Powell has highlighted his desire to follow a new doctrine: “pragmatic risk management."

This approach is characterized by an unusually candid assessment of uncertainty surrounding what can be considered as neutral monetary policy — policy that is neither expansionary, nor contractionary.

In this uncertain environment, Powell appears intent on raising rates gradually while constantly monitoring the economy for any signs of a slowdown or bubbling risks.

The monetary policy risk therefore stems from the possibility of “excessive” tightening that would constrain private-sector activity and weigh on growth. While the Fed has a relatively poor track record of tightening policy “just enough” to ensure a smooth landing of the economy, Powell’s pragmatic risk management doctrine may avoid the Fed falling into prior pitfalls.

Finally, while fiscal policy has provided strong impetus to the economy over the past nine months and will likely continue to do so through mid-2019, the fiscal tailwind is likely to dissipate over time.

The Tax Cuts and Jobs Act and Bipartisan Budget Act are expected to add around 0.7 percentage points to GDP growth in 2018 and contribute around 0.5 percentage points in 2019. However, the marginal boost to growth will have largely vanished by 2020.

What is more, in the absence of new legislation, the economy could face a mini-fiscal cliff in 2020 as government outlays will fall back below the spending caps introduced by the Budget Control Act of 2011.

In short, while a simple examination of future policy conditions would indicate the race will soon be over, a more refined exploration refutes this conclusion.

While the economy may be more vulnerable to adverse shocks in 2019 and 2020, including a stronger dollar, weaker emerging markets growth, an adverse oil price shock or a stock market correction, nothing guarantees the boat will sink next year, or the year after.

By that time, the “2020 recession call” may no longer be fashionable.

Gregory Daco is the chief economist at Oxford Economics.