Why the U.S. Economy Won't Fall Into Recession Anytime Soon

NEW YORK (TheStreet) -- The U.S. expansion is entering its seventh year but is aging well and has plenty of room to run. Still, there have been plenty of ups and downs, and the economy's poor performance early this year rekindled concerns that the expansion was in serious jeopardy.

Based on the economic data, we believe the expansion is midcycle. This is typically the longest phase of the business cycle before moving into the late-cycle phase, characteristic of an overheated economy poised to slip into recession. Read More: U.S. Economic Expansion Is Not in Jeopardy

There are important questions. Is this expansion getting old, and will it age similarly to prior ones?

Long in the Tooth?

While we're probably closer to the next recession than to the beginning of the recovery, it's important to remember that expansions are getting longer. Expansions have lengthened because of structural changes, including reduced macroeconomic volatility from improved policy, better management of inventories the rise of the more stable service economy and technological change.

The current expansion is 72 months old, but age is in the eye of the beholder. The three expansions prior to the Great Recession lasted an average of 95 months. This is noticeably longer than the 58-month average for all expansions since 1945. The average duration of an expansion between 1860 and 1945 was 26 months.

While this expansion is already longer than the average since World War II, expansions don't die of old age. Expansions normally end when the economy overheats. For example, the past few expansions have ended a few years after the economy reached full employment, leading to an acceleration in wages and inflation and tighter monetary policy. We don't expect the economy to reach full employment until this time next year, implying the next recession wouldn't be until sometime in 2019.

Historical patterns are simply guideposts and should be interpreted carefully, particularly given that this expansion has been anything but normal. Focusing on when the expansion will end can cause some to overlook how the economy changes as the expansion matures.

Learning From History

The unusual nature of this expansion suggests that it could age differently. Historically, real GDP growth has moderated as the expansion matures. This is unsurprising because as the expansion ages, the economy begins to run into capacity constraints and monetary and fiscal policy transitions from being accommodative to restrictive.

Because timing is important, we broke each post-World War II expansion into thirds to gauge how parts of the economy have historically performed as each expansion matured. A universal definition of economic expansion is lacking, but for this exercise, recovery and expansion are used interchangeably.

How parts of the economy age is unsurprising. For example, capital spending contributes less to growth as the expansion phase of the business cycle matures. In post-World War II expansions, equipment investment's average contribution to real GDP growth is largest in the first third of the expansion, receding as the cost of investment increases and returns diminish.

Consumer spending's average contribution to GDP growth is also largest in the first third of an expansion. The release of pent-up demand is a big factor, as it provides a significant boost to consumption, particularly for durable goods early in the expansion. Also, low interest rates contribute to the rebound in durable consumption. Similar factors explain why residential investment's biggest contribution to growth comes early in the expansion, then fades quickly.

There are other identifiable patterns. On average, corporate profit ¿growth is noticeably stronger in the first third of an expansion than in the second and third. Productivity demonstrates a similar pattern. On the other hand, wages and population growth are stronger in the final third of an expansion.

This all suggests that the best times for the current expansion have passed. But history doesn't always repeat itselfRead More: Deep Dive Into U.S. Personal Income

Why This Time Is Different

Historical averages are not explanations, and this expansion will likely age differently. Also, it's tricky to compare the economy's performance during past expansions because demographic characteristics differ.

Still, not only does this expansion not show signs of significant wear and tear, but the unusual nature of the recession and early expansion will cause its later stages to buck historical trends. Therefore, while the expansion could be entering its final leg, this could be its best yet.

Real GDP growth has accelerated this expansion, bucking the historical norm. There are a couple of explanations. First, the economy was emerging from a financial crisis rather than a garden-variety recession. The financial crisis cast a longer shadow over the economy, making it take longer to find a rhythm.

Further, the initial stage of the expansion was slow as households and businesses needed to continue to deleverage. Also, fiscal policy turned restrictive very quickly. Not since the military drawdown after World War II had the economy faced as much fiscal drag as it did during this recovery. The availability of credit is another issue, particularly for households. Usually this recovers quickly early in an expansion, but that didn't occur this time.

Though the duration of this expansion has been long, there is still a sizable output gap. Therefore, the economy won't run out of spare capacity soon, and this will keep inflationary pressures at bay. Hence, the Federal Reserve plans to tighten monetary policy gradually.

Even as the Fed begins to normalize interest rates, monetary policy will remain extremely accommodative. Also, the Fed's balance sheet will remain enormous, keeping long-term rates lower than they otherwise should be -- a form of stimulus that didn't occur during the tail end of the past few expansions. Read More: Deep Dive Into U.S. GDP 

Rising interest rates will provide an ironic boost to housing. In contrast to past recoveries, housing has contributed little to growth this expansion. Higher interest rates could create an urgency for potential homebuyers to enter the market. Mortgage rates have moved higher at times during the expansion with mixed implications for sales. However, as the Fed tightens it should alter expectations about the future path of mortgage rates.

We are not building enough homes either. Based on population growth and attrition, housing starts should be near 1.8 million units per year over the next couple of years. Therefore, a large portion of the housing recovery is still to come.

Wage Gains Boost Spending

Wage growth has been mediocre for most of this expansion but is poised to accelerate as in past expansions. Because the relationship between wage growth and consumer spending is stronger this cycle than most, larger wage gains will provide a boost to spending. That means spending could add more to growth in the final leg of this expansion than it did earlier this cycle, or at similar junctures of past expansions.

There will be possible exceptions. Capital spending has followed a pattern similar to past expansions. One reason is that pent-up demand may have been worked off over the past few years. Businesses may also not need to invest as much in equipment because the economy's potential has declined. Businesses are already spending more on equipment per worker than at any time in history. With the supply of labor not increasing as quickly, there may be less need to invest in equipment.

Demographic Issues

The demographic composition of the U.S. will set the later portion of this expansion apart from others. The share of those 65 and older is expected to continue to climb because of the aging of the baby boomer generation and increasing life expectancy.

Over the next couple of years this will weigh on consumer spending and the labor force participation rate and potentially shorten the expansion by causing the economy to achieve full employment faster. The potential offset to this is the pent-up demand to form households. The prime working-age group has started to expand again. Growth in the prime working-age group will accelerate and be fairly strong just as the economy enters the next recession. Read More: U.S. Economic Expansion Is Not in Jeopardy

 

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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