The longest expansion

Our current expansion in Gross Domestic Product (GDP) began in July 2009. In July 2019 it reached its 121st month, making it the longest expansion in U.S. history. There was no recession in the decade of the 20-teens. That’s the first such decade in U.S. history. The unemployment rate was 3.5 percent in November. It hasn’t been lower in more than 50 years. Inflation remains low, 1.8 percent over the past year. The core rate excluding volatile oil and food prices was only 2.3 percent.

That’s a lot of good news. Yet 2019 had its concerns. Real output growth fell back to a disappointing 2 percent, its average during this expansion, after near 3 percent growth in 2018. Recession signals flashed warnings. Manufacturing employment declined. Financial markets were unsettled. The yield curve inverted. The Federal Reserve reversed course and began cutting its policy interest rate.

We have reasons to be optimistic. We have reasons to be pessimistic. What will happen in 2020, the first year of a brand-new decade?

Production capacity constrains growth

Growth is constrained by spending during the early years of recovery from recession. Plenty of resources are unemployed and ready to produce products. What matters is whether consumers, businesses, the government or the world want to buy those products. Once resources are fully employed, though, output is constrained by the growth in available resources, and productivity growth. Spending increases beyond capacity growth merely causes inflation.

It’s hard to tell exactly when an economy’s resources are fully employed. For twenty years we thought that a 5 percent unemployment rate marked full employment. Unemployment hit 5 percent in September 2015. Then it continued to fall, but inflation remained low.

The Bureau of Labor Statistics counts people as unemployed if they are not working but searching for work. The BLS also measures job openings, when businesses have an open position and are searching for an employee. In March 2018 the number of job openings first exceeded the number of people searching for work. The unemployment rate was 4.0 percent that month. As of September 2019, there were 1.2 million more job openings than unemployed people.

By this measure, the U.S. economy reached capacity in the first quarter of 2018, at 4 percent unemployment. Since then growth has been constrained by the capacity for production.

Growth of capacity

Real GDP growth can be divided into four components on the production side: population, labor force participation, the unemployment rate and productivity. That’s how many people could be working, how many want to be working, how many are working, and how much each employee is producing.

The BLS measures the non-institutional population 16-years-of-age and older. Population growth depends mostly on fertility 16 years ago, plus current mortality and net immigration. It’s been growing by one percent per year on average during this expansion, and by eight-tenths percent per year since the first quarter of 2018. This growth should continue.

Labor force participation measures the percentage of the population who are working or searching for work. It’s 63.2 percent in November 2019. Participation has been edging upward, adding 0.4 percent per year to output growth. Participation peaked at 66.2 percent before the last recession. Ten years into this expansion, it’s clear that we’re not going to approach that high rate. Rising labor force participation is unlikely to add more than a few tenths to output growth going forward.

Each one-tenth drop in the unemployment rate adds about a tenth to real GDP growth. The unemployment rate is 3.5 percent in November 2019, down from 4.0 percent in March 2018. The last time it was lower was in May 1969, at 3.4 percent. The last time it was lower than that was in October 1953, at 3.1 percent. The unemployment rate cannot fall much further, so there is no added growth to be had here.

The wild card is productivity, measured by real GDP per employee. Productivity depends on the skills of the workforce, and the quantity and quality of the tools and materials they use. Since the first quarter of 2018 productivity been rising slowly, at one percent per year. That’s also the average since 2006, at the end of the productivity boom associated with information technology. One percent is a good guess for productivity growth.

Add it up: eight-tenths from population growth, four-tenths from labor force participation, no change in unemployment, and one percent from productivity growth. That’s real GDP growth of 2.2 percent. It’s the new normal.

If we are to forecast departures from that normal, we’d better have good reasons. Only labor force participation and productivity seem likely to vary on the capacity side.

There are 1.2 million more job openings than people searching for work. This should cause wages to grow, and they did, by 1.9 percent above inflation in 2019. This is slower than during the low unemployment years of the late-1990s, but about as fast as peak growth during the 2001-07 expansion.

Wage growth may be a reason why labor force participation has been edging upward. With labor scarce, wages should continue to rise, and perhaps this could add to growth.

Predictors of productivity growth are hard to come by. Investment in research and development has picked up in the past two years, growing by about 10 percent a year compared to 6 percent earlier in the expansion. But investment in business buildings and equipment is actually lower now than a year ago. Let’s take a wait-and-see perspective on productivity growth.

Spending

Increased spending cannot add much to growth with output at capacity. More rapid spending would add to inflation. A spending drop could pull output below capacity, though. That’s a recession.

Consumer spending continues to grow, and consumers remain confident. The University of Michigan’s consumer confidence survey shows no change from the optimism of the past five years. Low unemployment, rising wages and rising home prices are reasons.

Businesses investment, on the other hand, has decreased over the past 2 quarters, despite very low corporate bond interest rates. Orders for durable goods have dropped in 2019. Uncertainty over trade policy and a lack of exciting investment opportunities may be the reasons.

The Federal government is contributing to spending growth. The Federal deficit is increasing. The 2017 tax cut does not appear to have increased investment, but it probably has added to consumer spending. Retiring baby-boomers are behind the increase in Social Security and Medicare spending.

Both exports and imports have declined as a share of GDP. The trade war is a reason. The export share has actually fallen more than the import share, so the trade balance has moved towards a bigger deficit. That’s a subtraction from spending.

Consumers and the Federal government are contributing to spending growth. Investment and trade are not. An extraordinary spending jump to fuel inflation seems unlikely. But what about an extraordinary drop, to cause recession?

Will there be a recession in 2020?

The yield curve inverted in May 2019. Ordinarily the ten-year Treasury bond interest rate is higher than the rate on 3-month Treasury bills. But lenders and investors move their money to long-term bonds when they fear recession. Interest rates on those bonds decrease; rates on short-term bills increase. They invert when the short-term rate moves above the long-term rate.

Over the past 50 years yield curve inversions have been perfect predictors of recession. All seven recessions since 1970 have been preceded by inversions, and every inversion was followed by a recession, 5 to 16 months later. So, our inversion in May forecasts a recession by September 2020.

But go back 53 years, to 1966. The yield curve inverted and a recession did not follow within a year and a third. The Federal Reserve had increased interest rates in response to low unemployment and rising budget deficits, fearing inflation (correctly, as it turned out). Financial markets became pessimistic. Under pressure from President Johnson, the Fed reversed course.

Our Fed has reversed course as well. They increased the federal funds interest rate 9 times from December 2015 to December 2018, in response to low unemployment and rising budget deficits. Financial markets became pessimistic, the President applied pressure, and the Fed changed its policy, cutting the rate three times in 2019. Perhaps this will be enough to prevent a recession, as it did in the 1960’s.

A Forecast.

Let’s suppose that recession is avoided in 2020, and the expansion moves into its 12th year. Real GDP will grow at the normal rate, 2.2%. The unemployment rate will remain at its rock-bottom low of 3.5%. The all-items inflation rate tends to move towards the core rate, which is 2.3%, so expect inflation at that rate. The Fed says they’re done reducing the federal funds rate unless the economy deteriorates. The 3-month Treasury bill interest rate moves in lock-step with the Fed’s policy rate, so it should remain near 1.7%, where it was in November. Rising inflation should increase the 10-year bond interest rate by half-a-point, to 2.3 percent.

In other words, it’s a prediction for another normal year in our longest, slowest, steadiest expansion.