A peek at the growth peak hypothesis
admin | November 2, 2018
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The drop in US real GDP growth from 4.2% in the second quarter to 3.5% in the third has left some investors concerned the economy has passed its peak and could decay into weakness and ultimately contraction. The corollary then becomes that the Fed should not be raising rates. But this concern ignores the structure of past recoveries. If the Fed can successfully execute a soft landing, as it did in 1994, there is no reason the economy cannot continue to move ahead for several more years. The current expansion is far from being a has-been.
The swoon in equity prices in October and the cooling of real GDP growth to a 3.5% annualized pace in the third quarter from a stellar 4.2% Q2 reading have generated considerable speculation that the economy and corporate earnings have already peaked and that it may be “all downhill from here”. In a sense, the “peak growth” story could well be correct. The economy was probably never going to be able to sustain 4.2% growth, which was boosted substantially by a recovery from a tough winter and a depressed Q1 GDP reading. However, 3.5% real growth is nothing to sneeze at, especially in this expansion, when real growth has averaged about 2¼%, a historically anemic performance. Even a further cooling in the current quarter to, say, 3% 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 of 1.8%.
More importantly, the presumed implications of peak growth are 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. Thus, if the “peak growth” narrative were true, then most expansions would essentially be over not long after they started.
The classic example of this pattern 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%, an era labeled “Morning in America” by Ronald Reagan’s re-election campaign. While growth had not surprisingly already started to ease back somewhat by the end of that election season, the expansion continued all the way until 1990, at the time the second-longest business cycle in modern history.
Exhibit 1: Four-quarter average of real GDP growth – 1980s
There are some interesting analogies between the 1980s and the current decade. A major tax reform bill in 1986 helped to give the expansion a second wind at a time when growth had been decelerating for two years straight in 1985 and 1986. 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 back over 4% for much of 1987 and 1988. Unfortunately, the Fed was slow to reverse its easing as growth gathered momentum, ultimately producing an overheated economy. Core inflation surged in 1988 and 1989, forcing the Fed to clamp down hard. The expansion ultimately succumbed to the double whammy of tight monetary policy and oil shocks caused by the first Iraq War in 1990.
The 1990s expansion was less typical. The recovery phase of the cycle in 1991 – 1992 struggled, 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. Ironically, economic growth was surging at exactly the time that market participants were dealing with the Russian debt default and the Long-Term Capital meltdown, leading to another instance where the Fed eased policy ill-advisedly – or, at a minimum, was too slow to reverse themselves — in response to financial volatility. The speculative frenzy, especially in dot.com start-ups, ultimately went too far, leading to a stock price collapse in 2000 and the end of the expansion in early 2001.
Exhibit 2: Four-quarter average of real GDP growth – 1990s
The 2000s expansion performed closer to the textbook 1980s pattern, as the four-quarter real growth pace peaked in late 2003, at least partially in response to the tax cuts that were passed in 2001 but only took full effect in 2003. The expansion lasted almost five more years before excesses brought on by easy monetary policy and the housing boom reversed, leading to the worst economic downturn since the 1930s and a financial crisis. Of course, if the Federal Reserve had followed the “peak growth” narrative corollary that it should not raise rates when growth is decelerating, then it would never have hiked at all. The first rate move in the 2000s did not come until June 2004, six months after the four-quarter average of real GDP growth peaked!
Exhibit 3: Four-quarter average of read GDP growth – 2000s
The Current Expansion
The current cycle has had its own share of irregularities. The recovery was anemic for several years before finally gathering momentum in 2014 and early 2015, though the rigor proved to be short-lived as growth cooled steadily in 2015 and early 2016 before perking up again. Like the 2000s, the Federal Reserve did not even begin to normalize monetary policy until well after growth had already peaked. Like the 1980s, a major tax reform package deep into the business cycle has generated renewed economic momentum. Indeed, the pickup over the past two years in the four-quarter average of real GDP growth has been about 150 bp, similar in magnitude to the acceleration seen in 1987. Growth on a four-quarter basis will probably not reach the 3.8% high-water mark of early 2015, so “peak growth” for this cycle is almost four years in the rearview mirror.
Exhibit 4: Four-quarter average of read GDP growth – 2010s
The common patterns of the past several economic cycles and 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 exacerbated by a discrete event. 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 a soft landing, 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. Even if the economy has already seen its peak growth, the expansion need not be viewed as a has-been.