Markets and Economy

5 Lessons From 1Q 2019

The economy started out strong in the first few months of 2019, but how it will evolve over the rest of the year hangs largely on five main issues. From whether a recession is on the horizon to the future of global growth, these lessons from the first quarter can help businesses plan for the coming months.

The economy started out strong in the first few months of 2019, but how it will evolve over the rest of the year hangs largely on five main issues. From whether a recession is on the horizon to the future of global growth, these lessons from the first quarter can help businesses plan for the coming months.

1. Recession Worries Have Faded (for Now)

Recession speculation dominated headlines at the end of 2018, as a 20 percent tumble in the equity market sparked fears of an imminent downturn. But the stock market has rebounded in the first quarter; volatility is back to levels consistent with robust economic times.

Although no major imbalance appears to be threatening the expansion, history supports the instinct to worry. Whether it’s contracting or expanding, the economy rarely stays put for long.

But expansions do not simply expire from old age, or end when unemployment falls below a certain threshold. Recessions require a trigger: either the rapid deflation of an asset bubble, or the emergence of inflationary pressure that makes borrowing costs prohibitive. With no apparent trigger on the horizon, the expansion seems likely to endure for a while longer.

2. The Fed Is Working to Keep Its Inflation Target Credible

To effectively fight the next downturn, the Federal Reserve will need leverage. The official 2 percent inflation target helps provide that leverage by anchoring expectations. As long as investors find the target credible, in the event of a recession, policymakers will be able to cut interest rates by at least 2 percentage points below their natural equilibrium.

But if investors start to believe inflation will fall short of 2 percent over the long run, then the Fed’s power to counteract a downturn will be constrained. Rates can only be cut to zero; if they’re already below 2 percent, the Fed may not be able to push down borrowing costs enough to encourage capital investment and hasten a recovery.

To maintain the target’s credibility, the Fed has adopted a symmetrical approach that will tolerate inflation in excess of 2 percent when the economy is strong. A period of above-target inflation will be necessary to balance out the persistent undershoot of price growth during the recovery.

The Fed’s acceptance of a symmetrical target should give freer rein to growth through the top of the business cycle. Policymakers may allow growth to continue accelerating, even if inflation begins to modestly exceed the official target.

3. Disappointing Global Growth May Rebound

Global growth was disappointing in 2018, but last year’s drags on the international economy may prove transitory. Asian economies expanded only 4.5 percent for the year, missing forecasts by a full percentage point. The region’s slowdown was concentrated in Japan, where natural disasters may have dampened growth. Chinese expansion also fell short of expectations, likely due to flaring trade tensions with the US.

Uncertainty about Brexit and weakening demand from China contributed to slower growth in Europe, but 2019 should bring a resolution for these issues. The outcome of Brexit negotiations is still in doubt, but the deadline for a compromise is fast approaching. Meanwhile, the US and China appear to be moving closer to a trade agreement. The resolution of these political uncertainties may create a rebound in global growth as businesses feel more confident making strategic capital investments and expanding overseas.

4. Bond Markets Seem Indifferent to the Fiscal Outlook

The Congressional Budget Office (CBO) forecasts the emergence of a massive structural deficit that will eventually overwhelm bond markets. As the population ages, the American workforce will grow more slowly, and spending on entitlement programs like Medicare and Social Security will steadily climb. Official projections show the federal deficit growing unsustainably over the coming decades, consuming an ever-larger share of capital markets and eventually crowding out private investment.

Yet bond markets remain tranquil, with long-term yields holding at historically low levels. A closer look at the CBO’s forecasts shows that faster future growth could dramatically brighten the nation’s fiscal outlook. Official forecasts call for GDP growth to plateau at a conservative 2 percent, but this is far from a certainty. Emerging technologies could boost worker productivity, and increased immigration could counteract the demographic decline that is causing workforce growth to slow. If immigration reform allowed businesses to fill the 7 million job openings that are going unfilled today, the nation’s GDP growth could accelerate by approximately half a percentage point annually.

A modest acceleration in growth could head off the fiscal crunch. If the economy can maintain its current 3 percent growth rate over the next 20 years, the fiscal crisis likely would become far more manageable. As a percentage of GDP, budgetary shortfalls would rise only slightly from their current level, and relatively minor legislative changes could realign benefits with revenues.

5. Populism Could Upend Profits

The bull stock market has created tremendous wealth for US households, but the market’s gains have been driven by a structural shift in the economy that’s creating political tension.

After-tax corporate profits have climbed to a 10 percent share of GDP, up from their historical 6 percent average. And the rise in profits has accompanied a steady decline in the share of the economy going toward workers’ wages. This has fueled a resurgent populist movement, which would like to see changes to the tax code to address this structural shift.

Such a move could be counterproductive—if profits returned to historical levels, equity prices could fall. However, legislation is unlikely to reverse the changing structure of the economy, which is largely being driven by technological innovations, such as e-commerce and automation, as consumers enthusiastically embrace better ways to shop and manage their personal lives. Ultimately, the populist movement should focus on solutions that improve financial security for wage earners without derailing the tech-centric engines of growth.

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Jim Glassman, Head Economist, Commercial Banking

Jim Glassman

Jim Glassman, Head Economist, Commercial Banking

Jim Glassman is the Managing Director and Head Economist for Commercial Banking. From regulations and technology to globalization and consumer habits, Jim's insights are used by companies and industries to help them better understand the changing economy and its impact on their businesses.

Economy Outlook Jim Glassman