The economy may have peaked, but it's not a has-been

The economy may have peaked, but it's not a has-been
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The swoon in equity prices in October and the cooling of real GDP growth to a 3.5-percent annualized pace in the third quarter (Q3) from a stellar 4.2 percent in Q2 have generated considerable speculation that the economy has already peaked and that it may be “all downhill from here."

In a sense, the “peak” story could well be correct. The economy was probably never going to be able to sustain 4.2-percent growth, which was boosted substantially by a recovery from a tough winter and a depressed Q1 GDP reading.


However, 3.5-percent real growth is nothing to sneeze at, especially in this expansion, when real growth has averaged about 2.25 percent, a historically anemic performance.

Even a further cooling in the current quarter to, say, 3 percent would still leave the economy in a far better place than it has been for most of the decade and light years ahead of the Federal Reserve’s estimate for the longer-run growth potential (1.8 percent).

More importantly, the premise of “peak growth” is flawed. In reality, a textbook economic cycle will register its fastest growth during the early stages of a recovery and growth can be expected to slow as the expansion matures.

The classic example of this would be the 1980s expansion, the last time that the U.S. economy suffered through a recession remotely similar to the one that accompanied the financial crisis in 2008-2009.

In the 1980s, economic growth exploded after the recession ended in late 1982. A four-quarter average of real GDP growth peaked in the first quarter of 1984 at a stunning 8.6 percent, an era labeled “Morning in America” by Ronald Reagan’s re-election campaign.

The expansion continued all the way until 1990, at the time, the second-longest business cycle in modern history.

There are some analogies between the 1980s and the current decade. A major tax reform bill in 1986 helped to give the expansion a second wind. In addition, new Federal Reserve Chairman Alan Greenspan responded to a severe stock market crash in late 1987 by easing Fed policy.

The combination of monetary ease and fiscal boost helped to push real GDP growth over 4 percent for much of 1987 and 1988. Unfortunately, the Fed was slow to reverse its easing, which ultimately produced an overheated economy.

Core inflation surged in 1988 and 1989, forcing the Fed to clamp down hard and ultimately the expansion succumbed to the double whammy of tight monetary policy and the oil shock caused by the first Iraq War in 1990.

The 1990s expansion was less typical. The recovery phase of the cycle, in 1991 and 1992, was a struggle, but growth took off in 1993 and 1994, setting what looked like it would be the peak for the cycle in 1994.

However, the internet revolution and a capital gains tax cut helped to generate an investment boom in the late 1990s that drove a new peak in growth for the cycle in 1998.

The speculative frenzy, especially in dot-com startups ultimately went too far, leading to a stock price collapse in 2000 and the end of the expansion in early 2001.

The 2000s expansion performed closer to the textbook 1980s performance, as the four-quarter real growth pace peaked in late 2003, at least partially in response to the tax cuts that were passed 2001, but which took full effect in 2003.

The expansion went on for almost five more years before the excesses brought on by an era of easy monetary policy and the housing boom reversed, leading to the worst economic downturn since the 1930s and a financial crisis.

The current cycle has shown its own share of irregularities. The recovery was anemic for several years before finally gathering momentum in 2014 and peaking in early 2015, though the rigor proved to be short-lived as growth cooled steadily in 2015 and 2016 before perking up again in 2017 and this year.

Like the 1980s, a major tax reform package well into the business cycle has generated renewed economic momentum, though I do not expect that growth on a four-quarter basis will quite reach the 3.8-percent high point of early 2015.

In any case, the pattern of the past several economic cycles as well as the peculiarities between them underscore the fact that reaching a peak in the speed of growth is not a death sentence for an expansion.

As Fed officials have noted, economic expansions do not die of old age. They typically end when an accumulation of excesses build up to a tipping point, often helped along by a discrete event (such as an oil shock).

Even if real GDP growth slows sequentially in the current quarter and again in Q1, the four-quarter average may well continue to accelerate through the first quarter of next year. The Federal Reserve’s gradual rate hike strategy is an effort to fend off the buildup of the sort of imbalances that have in the past led to recessions.

If the Fed can successfully execute, as it did in 1994, there is no reason that the economy cannot continue to move ahead for several more years in the absence of a big external shock. In short, even if the economy has already seen its “peak growth,” the expansion need not be viewed as a has-been.

Stephen Stanley is the chief economist at Amherst Pierpont and a regular guest on CNBC and Bloomberg Television.