Trump taking credit is a sugar high

During the second quarter of 2018, the U.S. economy grew at over 4 per cent on an annualized rate, something that had not occurred in more than four years. President Donald Trump immediately announced that this record growth is attributable to his leadership and policies, especially with the “gigantic” tax cut of last year. That working stiffs are seeing very little benefit was not mentioned.

The validity of Trump’s assuming all the credit for the growth rate (which some economists have likened to a “sugar high”) is debatable, but it is true that the U.S. has enjoyed positive growth for more than nine years.

Expansions of such duration are exceedingly rare, so the critical question is “When can the next recession be expected?”

One statistic that has consistently forecast downturns accurately has been an inverted yield curve. That is when the yield on long-term bonds falls below the yield on short-term bonds (bonds due in less than one year but especially those with 90 days to maturity).

Short-term rates reflect the cost of borrowing at the central bank for commercial banks and so are really determined by the central bank. Long-term rates reflect the average short-term rates over a bond’s lifetime as well as a “term premium” — in effect an extra return for holding the debt longer.

Both the Federal Reserve in the U.S. and the Bank of Canada have been raising their short-term rates - the Federal Funds rate in the US and the Bank Rate in Canada - while longer-term rates have not risen as fast. So the differential between the two rates has drastically shrunk from a high of almost 3 per cent to something close to 0.25 of 1 per cent. Inversion is getting close.

What does inversion of the yield curve mean in practical terms?

First, it might mean the market expects short-term rates to fall in the immediate future as the central bank moves to stimulate a weakening economy. At the same time, markets may believe that long-term yields may not rise much in future. This would be the case if expectations are that inflation will not occur in future, or if investors want to increase their holdings of long-term debt because they are searching for safety.

Recent research indicates that an inverted yield curve forecasts a recession within a year is not just a folk myth. The research also indicates that yield-curve inversion is a better predictor of a recession than most professional economic forecasters. If this is so, you would expect the central banks to start relaxing monetary restraint once the yield — curve seemed close to inversion.

The evidence that central banks have learned from this demonstrated predictability is, at best, mixed. How come? Well, central banks, like the rest of us, make mistakes. The chair of the Fed back in 2006 said the yield-curve inversion was the result of heavy buying of long-term bonds by foreign central banks and pension funds and not a forecast of a recession. Boy, was he wrong! Central banks often overestimate the strength of a boom and continue restraint when just the opposite is the correct economic medicine.

And because the impact of monetary policy is only felt after a lag of one or two quarters, they often discover their error only after the downturn is well underway.

Many market economists hold a strong belief that central bankers in the developed world are much more concerned with inflation than they are about levels of unemployment. With the current rate of unemployment in both Canada and the U.S. at record lows, both central banks are predicting a continuous rise in the short-term rate (and in borrowing costs for businesses and consumers) until pressure in labour markets eases. But, given the lags mentioned above, the two central banks may keep restraint on longer than warranted. That will be a mistake.

My estimation is for a downturn beginning in mid-2019. But I could be wrong.

David Bond is a retired bank economist who resides in Kelowna.