LONDON (Reuters) - Like booms, recessions help individuals and businesses make sense of changes in the level of economic activity and drive those changes with their impact on spending and savings.
As the world economy slows, the U.S. Federal Reserve is now openly discussing an interest rate cut designed to ensure a recessionary narrative does not take root and to keep the economy expanding.
“A recession ... is a time when many people have decided to spend less, to make do for now with that old furniture instead of buying new, to postpone starting a new business, to postpone hiring new help in an existing business, or to express support for fiscally conservative government,” Yale economist Robert Shiller told the American Economic Association (“Narrative economics”, Shiller, 2017).
Disturbances that spark a downturn can vary. Bank failures, poor harvests, earthquakes, stock market crashes, real estate busts, post-war demobilisations and monetary policy mistakes have all been blamed for initiating recessions (“The Panic of 1907: Lessons from the Market’s Perfect Storm”, Bruner, 2007).
The initial disturbance need not be major but it spreads through the economy and is amplified by the existence of positive feedback as households, businesses and financial intermediaries all try to reduce risk exposure at the same time(“General Theory of Employment, Interest and Money”, Keynes, 1936).
If policymakers want to avoid recession, they must avert the initial disturbance through regulation or prevent it propagating and accelerating through the system.
Recessions are caused not so much by the initial disturbance as by the second and third-round responses to it by individuals, firms, banks and governments. Tempering those reactions is normally the priority for policymakers.
In the current slowdown, the origin was likely the rise in economic tensions between the United States and China and the associated impact on business confidence and investment.
Manufacturing and trade growth peaked in the second and third quarters of 2018, before the economic conflict escalated and started to weigh on business and investor confidence.
Fading fiscal stimulus from U.S. tax cuts and increasing interest rates around the world over the course of 2018 contributed to the slowdown.
But the slowdown so far has been mostly confined to business investment, manufacturing production, new orders, construction activity and freight movements.
By contrast, employment, wages, consumer confidence, household spending and the much-larger services sector have stayed relatively buoyant.
The result has been the emergence of a dual-speed economy. Freight growth has slowed to a crawl, while passenger transportation is still growing at some of the fastest rates since the recession of 2008/09.
As long as the downturn remains isolated in the manufacturing sector and does not spill over into the labour market and services sector, the economy is likely to continue expanding, as it did in 2015/16 and 1998/99.
The case for the Fed and other major central banks to cut interest rates early and aggressively rests on the idea that such a move can prevent weakness spreading from manufacturing to the rest of the economy.
The aim would be to provide psychological reassurance and discourage households, businesses and banks from turning more cautious and trying to reduce spending and lending.
The case for rate cuts is often framed in terms of taking out “insurance” against a deeper downturn but might be better thought of as a “firebreak” to insulate the domestic services sector from weakness in manufacturing and the global economy.
“Our contacts in business and agriculture reported heightened concerns over trade developments,” Fed Chair Jerome Powell said on July 10 (“Semiannual monetary policy report to the Congress”, Powell, July 10).
“Growth indicators from around the world have disappointed on net, raising concerns that weakness in the global economy will continue to affect the U.S. economy,” he warned.
“These concerns may have contributed to the drop in business confidence in some recent surveys and may have started to show through to incoming data.”
In 1998, following the Asian financial crisis, the Fed insulated the United States from a global slowdown by cutting rates by 75 basis points. It is likely to try something similar this year.
The firebreak arguably created the conditions for the equity market boom and bust in 1999/2000 and contributed to the severity of the eventual downturn.
But policymakers are likely to conclude that that is a problem to be left for the future and to focus on the more immediate challenge of sustaining confidence.
John Kemp is a Reuters market analyst. The views expressed are his own.
- Fed likely to cut interest rates if U.S. manufacturing continues to slow (Reuters, May 2)
- Oil and equities prepare to party like it’s 1999 (Reuters, March 19)
- Fed’s next move more likely to be a cut in interest rates (Reuters, March 7)
- Storytelling in oil and other markets (Reuters, Feb. 8)
Editing by Edmund Blair
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