Is The Business Cycle Dead—Or Just In Remission?

Is the US economy trapped in what might be described as a macro version of Dante’s Nine Circles of Hell? No one knows the answer at this point, but the possibility may be rising that the US economy is destined to hobble along with tepid growth while avoiding a formal NBER-defined recession. In that scenario, the Federal Reserve can’t raise interest rates or “normalize” policy, leaving the economy in a perpetual state of dysfunction.

The latest chapter in this dilemma is set to unfold in tomorrow’s Fed announcement, which is widely expected to leave interest rates unchanged. Futures markets are pricing in an 88% probability that the central bank will stand pat, based on CME data as of Sep. 19. As a number of economists have pointed out recently, the Fed is unlikely to surprise the market with a rate hike at a time when the crowd’s convinced that another round of tightening is highly unlikely.

“We had a weak first half, then a month or two of better data and now a month of softer data,” says Avery Shenfeld, chief economist at CIBC Capital Markets. “Have we put the soft data from the start of the year clearly behind us? I would have to say no.”

But hope springs eternal. The Atlanta Fed’s GDPNow model (as of Sep. 15) is currently projecting a 3.0% increase in third-quarter GDP (seasonally adjusted annual rate)—sharply above the roughly 1% gains that have prevailed in each of the previous three quarters. If the sunny estimate holds up when the Bureau of Economic Analysis releases the official Q3 report on Oct. 28, the news could materially reshape expectations for the better about the strength of the US economy.

But doubts persist in the wake of the disappointing numbers for August. Survey data via the ISM Manufacturing Index dipped into contractionary territory for the first time in six months. ISM’s survey figures for the services sector still reflect growth, although the sharp deceleration in August that left the non-manufacturing benchmark at a six-year low at just above the neutral mark is hardly the basis for optimism.

“The latest set of ISM numbers is shockingly weak,” advises Joshua Shapiro, chief US economist at Maria Fiorini Ramirez Inc. “It certainly gives the doves at the Fed more ammunition.”

The hard data for August has been weak too. Industrial production and retail sales contracted last month, delivering a one-two punch of downside surprises relative to expectations.

“Overall, the August retail sales report confirms our suspicions that third-quarter GDP growth will probably come in softer than we initially expected,” notes Steve Murphy at Capital Economics. The consultancy’s estimate for Q3 continues to project growth at 2.5% for GDP, but “the balance of risks to that forecast now probably lie to the downside.”

Inflation, on the other hand, is showing signs of creeping higher. Consumer prices inched up in August, rising 1.1% over the last 12 months at the headline level. Core CPI, which strips out food and energy and is considered a more reliable measure of the trend, gained 2.3% for the year–slightly higher than the previous month’s year-over-year advance. That’s above the Fed’s 2.0% inflation target, suggesting that the pressure is growing for a rate hike. “The economy may not be firing on all cylinders, but growth is enough to spark a little more inflation than we thought,” says Chris Rupkey, chief economist at MUFG Union Bank.

But if the momentum is building for more policy tightening, it’s not obvious in Treasury yields. True, the 2- and 10-year rates have increased recently, but only after sliding sharply in the summer. Unless yields continue rising in the weeks ahead, it appears that the downside bias that’s been in force this year is still intact.


The key question is whether the Fed will be able to materially raise rates before the next recession hits? Although the central bank still has various policy tools at its disposal beyond cutting rates, the onset of a new downturn with Fed funds still close to zero would be unprecedented and, by some accounts, ominous because the standard monetary weapon would have limited, perhaps zero, capacity for juicing growth.

But maybe the real issue is that the economy is stuck in a netherworld where growth remains perpetually weak while unusually low interest rates keep the macro trend from falling into a conventional business-cycle ditch. Actually, we’ve been in something approximating this netherworld in recent years, albeit punctuated by temporary bursts of relatively solid growth.

The Federal Reserve’s agenda in tomorrow’s announcement is explaining how or if anything’s materially changed. Fed Chair Janet Yellen, once more, has the thankless task of telling us what’s really going on in tomorrow’s press conference that follows the release of the rate decision. But no matter what she says, it’s going to be hard to break free of the damned-if-you-do, damned-if-you-don’t trap.

Or as Dante wrote, “In the middle of the journey of our life I found myself within a dark woods where the straight way was lost.”

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