The typical economic cycle

 

Early expansion or recovery phase

A typical economic cycle starts with an early expansion (or recovery) phase when economic growth picks up from a low base. At this stage, the level of economic activity is still relatively low such that there is still a fair amount of productive capacity slack, thus economic growth happens with still low inflation. In addition, the central bank, which normally has a dual mandate of fostering healthy economic growth and combating inflation, will likely be maintaining a relatively loose monetary policy through low interest rates. This is because at this stage the central bank’s main concern is to boost economic growth (through low interest rates) and not to combat inflation (as inflation is still low). An analogy to car driving will be that this early expansion phase is akin to a driver just starting the car engine and stepping on the accelerator to get the car moving from a stationary stage.

 

Mature expansion or peak phase

The next stage will be the mature expansion (or peak) phase of the economic cycle. This normally happens after the early expansion phase has carried on for a while such that the level of economic activity is much higher now. This in turn results in lower productive capacity slack and exert upward pressure on the general price level of the economy. Inflation picks up and the central bank starts to worry about inflation and thus begins to tighten its monetary policy by raising interest rates. A higher interest rate helps to tame inflation by discouraging investments (as it becomes more expensive to fund investments through borrowings) and slowing the rate of economic growth. While it may seem to the reader that the central bank at this stage is playing the role of a spoilsport by disrupting the economic party, the negative consequences of letting the economy overheat and thus risking runaway hyperinflation is the nightmare of most central bankers. A study of past episodes of hyperinflation in Germany during the 1920s and more recently in Zimbabwe would make it clear that hyperinflation generally results in widespread disruption to economic activity and also generally comes with huge political consequences (for example witness the rise of Adolf Hitler post the significant political upheaval in Germany during the hyperinflation period of the 1920s). In addition, runaway hyperinflation generally would have a life of its own (through raising consumers’ inflation expectations) and is notoriously hard to tame. And to continue the analogy to driving, the mature expansion phase is akin to a driver now driving at or above the speed limit and has to start to apply the brakes in order to reduce the risk of an accident. Failure to do so could result in a runaway car and potentially subsequent ineffective brakes, similar to the situation depicted by the 1994 hit movie ”Speed”.

 

Contraction or recessionary phase

After the peak or mature expansion phase, comes the contraction or recessionary phase of the economic cycle. This happens when interest rates have risen to a relatively high level that economic activity not only slows down but also starts to contract. Investment slows, unemployment rises and discretionary consumption falls. This is the stage when an economic recession occurs and past excesses during the growth phase comes to haunt us. Companies that embarked on unsound expansion plans during the growth phase would now face financial difficulties and could even face bankruptcies. At this stage, the central bank, sensing that the balance of risk has shifted from inflation to growth risks, would start to engage in expansionary monetary policy by lowering interest rates (in an effort to stimulate economic growth again). Using our driving analogy, this is the stage when the brakes are working and the car is slowing down significantly.

 

Trough or bottoming phase

Lastly, we arrive at the trough or bottoming phase when economic growth stops contracting and starts to stabilize. The past excesses of the economy have also been adequately addressed by now. There could also be industry consolidation as weaker players are taken out (through potential mergers and acquisitions), thus removing any excess supply that may have built up in the economy during the growth phase. The central bank would also continue its expansionary monetary policy by further lowering interest rates, in a continued effort to stimulate economic growth. While economic activity still remains depressed at this stage and consumer still feels the pain of the economic recession, companies may start to see some early green shoots as pricing power improves with the reduction in excess supply. And back to our driving analogy, this is akin to the transition stage when the driver stops applying the brakes and starts to step on the accelerator again.

 

Longevity of an average economic cycle

Having went through the characteristics of the 4 stages of the economic or business cycle, the next key question to address will be how long is an average economic or business cycle? Based on data from the US National Bureau of Economic Research (NBER), there have been 11 economic or business cycles in the US from 1945 to 2009, with the average length of a cycle lasting about 69 months (or slightly less than 6 years). And the average expansion phase (early expansion and peak) lasted about 58 months (or slightly less than 5 years), while the average contraction phase (contraction and trough) lasted a much shorter 11 months (slightly less than 1 year).

 

Is this cycle different?

Deeper downturn during 2007-2009

The current economic cycle we are in since 2009 is slightly different from past economic cycles in three aspects. Firstly, the previous downturn experienced in 2007 to 2009 was by most measures a deeper and more significant recession compared to past recessions. This is likely because the 2007 to 2009 recession was triggered by the US sub-prime debt crisis, which in turn resulted in a deep correction in US residential property prices. And past studies have shown that recessions, which coincided with a residential property market downturn, tends to be deeper and more prolong. This is likely because of the important role of residential property or homes in the household balance sheet.

 

Choked monetary transmission resulted in very weak recovery

The second difference is that the recovery phase from the downturn in 2007-2009 was a very gradual or weak one and it took a much longer time for the global economy to return to pre-crisis output level. And due to this weak recovery, major central banks have to resort to extraordinary unconventional monetary measures (i.e. quantitative easing or QE for short) to stimulate global economic growth. Other than the fact that the recession from 2007-2009 was a very severe one, another reason for the very gradual or weak recovery was that the global financial system was very significantly hit by the prior crisis and was for many years not functioning properly to assist in the economic recovery. For example, many international banks were left in such a significantly weakened state (with low capital adequacy ratios) post the crisis that they were unable or have low risk appetite to extend lending to the rest of the economy. This, coupled with the additional regulatory requirements that governments and central banks imposed on the banking sector post the crisis, further discouraged banks’ lending activities for a number of years post the 2007-2009 crisis. While a lot of these additional regulatory requirements were enacted with the good intention to prevent a repeat of the global financial crisis in 2007-2009, it unfortunately had the negative side effect of discouraging normal lending activities by the banks and thus hindered the economic recovery process.

 

Thus, despite efforts by the major central banks (US Federal Reserve, European Central Bank and Bank of Japan) to drastically cut their interest rates to zero percent, economic growth did not significantly pick up for the first few years post 2009. While the central banks were loosening monetary policies (by cutting interest rates) and trying to pump additional liquidity into the financial system, the bulk of this additional liquidity failed to reach the rest of the economy. This is because the banks, which play an important liquidity transmission role through their lending activities, did not have the ability or risk appetite to significantly expand their lending activities. Thus, due to this choked monetary transmission mechanism, central banks initial monetary loosening efforts did not work and they have to eventually embarked on unconventional measures such as quantitative easing (i.e. buying of financial assets such as government bonds and mortgage-backed securities). To give an analogy, like the human heart that is responsible for pumping and ensuring the smooth flow of blood throughout the human body, the banking sector is akin to the heart of an economy, responsible for ensuring the smooth flow of liquidity throughout the economy. And a choked banking transmission system is akin to having a weak heart and thus poor blood circulation, which slows down the recovery process from an ailment.

 

Gradual recovery and technological advancements could mean structurally lower inflation

The last and most important difference in the current economic cycle is that the economic rebound we have witnessed in the last few years have happened without stoking any signs of significantly higher inflation. In fact, some developed economies (e.g. Europe) were at one point facing the risk of deflation as inflation remains stubbornly low and threatened to fall into negative territory over the last few years. One of the main reasons why inflation may have remained stubbornly low is that the current economic recovery phase is a very gradual and weak one (as we have highlighted in the earlier section). Thus, due to this gradual recovery, total output level of the global economy may still not be significantly above the 2008-2009 pre-crisis level and thus there may still be significant productive capacity slack (or supply) in the global economy.

 

Another important factor that may have kept inflation low recently is technological advancements, specifically with regards to the structural growth in e-commerce and the sharing economy. E-commerce, by cutting out the many levels of middleman between the producer of goods and the final consumer, have helped to bring lower prices to many consumers. And with regards to this aspect, I personally have experienced significant deflation with regards to the many items I purchased online. One recent example is a pair of basketball shoes that I bought online that cost only around SGD 30, which is significantly cheaper compared to my previous pair of basketball shoes that cost me around SGD 70 more than 5 years ago. And the deflationary impact of e-commerce does not just stay online as I believe the increase competitive pressure from e-commerce may have also prevented many offline retailers from raising prices liberally. Thus, e-commerce could keep inflation structurally low for the foreseeable future.

 

Other than e-commerce, the sharing economy such as ride-hailing services provided by Uber and Grab, and Airbnb, could also structurally anchor inflation lower in the near and medium term. The development of the sharing economy basically freed up or activate a lot of private idle resources and capacity, thus increasing the productive capacity of the whole economy. This higher productive capacity (or supply) of the economy will in turn help to keep inflation lower (as higher supply will generally lead to lower prices). For example, a part-time Grab driver that uses his/her private car to ferry Grab passengers is basically activating his/her previous private idle car for public usage. This in turn increase the total private hire car fleet capacity and thus help to keep fare inflation low for private hire cars and also taxis. The same impact is also exerted by Airbnb on the hotel industry in terms of keeping hotel room rates inflation low.

 

Here, I want to differentiate between cyclical factors and structural factors of inflation. While recently we have seen that inflation is starting to slightly increase from low levels in certain parts of the world (e.g. the US), this is likely to be a cyclical pickup in inflation as economy growth continues to rebound. Lower unemployment rate is normally one of the main drivers behind such cyclical increase in inflation. However, what I am arguing here is that there are also technological factors such as e-commerce and the sharing economy that could keep inflation structurally lower in the near and medium term. What this means is that while inflation may pick up cyclically, it is likely to be structurally lower than past inflation cycles, meaning we would likely see lower peaks and lower troughs in inflation rates in the current cycle.

 

Political backlash could end Goldilocks fairy tale

 

Goldilocks scenario

The economic implication of structurally lower inflation in the near to medium term (brought about by technological factors that were highlighted earlier) is that the major central banks in the world can afford to keep monetary policy loose or interest rates lower than normal for a longer period. This means that we could potentially expect the current interest rate hike cycle led by the US Federal Reserve (and likely to be followed by the other major central banks later) could be a gradual one with terminal peak interest rates (at the end of the hiking cycle) being lower than in past cycles. This in turn means that the current economic recovery phase can likely last longer and potential economic growth rates can be higher. Such a scenario is typically termed as a “Goldilocks” scenario by economists, as economic growth stays at healthy levels without stoking any inflation fears, i.e. a “not-too-hot, not-too-cold” benign scenario.

 

Unfortunately Goldilocks is a fairy tale

However, readers of bedtime stories would correctly point out that “Goldilocks” is a fairy tale and the current benign economic scenario painted in the previous paragraph (and which we are currently in to a certain extent) may not last for long without risk of a backlash. This is because the same technological factors that help to anchor inflation lower is also causing a widening income gap globally. This is expected as the richer segments of the population are normally the ones that are better educated (technologically) and have the financial resources to invest in the latest technological trends to benefit from them. One good example is the increase use of robotic technology and robots. Rich investors who can invest in robots to replace human employees (for example to run their factories or businesses) would likely see higher returns on their invested capital (as robots would normally function more efficiently and could even cost less than human employees). On the other hand, salaries of human employees (who are normally from the less wealthy segment of the population) would suffer as they risk being replaced by robots. This in turn would contribute to a wider income gap between the rich and poor.

 

And such a widening of income gap that we have seen in the past few years is leading to rising political dissent among the less wealthy segments of the population. Brexit and the unexpected electoral victory of President Donald Trump in 2016 are but just early signs of increase political dissent against the political incumbents and elite class. And I do expect such political backlash to likely continue in the near term across the globe, which could lead to more political uncertainty as incumbent governments are increasingly replaced or forced to change some of their capitalist policies. This in turn could lead to potential policy errors and risks that could shorten the life of this current economic recovery. One such prominent policy risk is the recent rise of protectionism (and the accompanying trade war concerns) that we have witnessed across the globe, which could pose a serious threat to economic growth. Thus, unlike past economic expansions which normally comes to an end due to rising inflation concerns (which force the central banks to tighten monetary policies and raise interest rates), the current expansion may be threatened more by political and policy changes.

 

Therefore, unless current incumbent governments take actions to address the widening income gap and pacify the less privilege segments of their populations, the current political backlash raging across the globe may continue to cause political uncertainties in many countries. While some governments may choose protectionist policies to narrow the income gap and pacify their voters, this may be achieved at the expense of slower economic growth for everyone. A better alternative may be to still pursue trade friendly policies and embrace technological advancements but recognise the negative side effects of such policies in terms of widening the income gap. Measures should then be taken to narrow the income gap by increasing social spending and transfers to the less privilege segments of the population. These are likely difficult policy decision to make but no one ever say that governing is easy. May you live in interesting times!