Don’t let the American economy hit stall speed

People shouldn’t be as worried as they are about the risk of a US recession. That said, it wouldn’t take much to trigger one, which is why the Federal Reserve should take out some insurance by providing added stimulus.
Market participants see all sorts of reasons to fret about an imminent slump. Global growth is slowing, trade wars are adding to uncertainty, the economic expansion is getting old and, until recently, yields on short-term Treasury bills were higher than those on long-term notes – the kind of “yield-curve inversion” that has tended to precede recessions.
I’m less concerned. Consumers are in good shape, and the Fed’s rate cuts have kept financial conditions easy. It takes more than age to kill an expansion: Typically, either unwanted inflation forces the Fed to snuff out growth, or some shock hits demand so hard and fast that the Fed can’t respond quickly enough to prevent a recession. The yield curve is flat not because short-term rates are high, but because long-term rates are so low. Investors are buying bonds as a hedge against bad outcomes on growth; they’re not worried about higher inflation. Importantly, monetary policy is still supporting growth, as can be seen in home sales and
residential construction.
What, then, can go wrong? Sometimes, an adverse event and human psychology can reinforce each other in such a way that they bring about a recession. Given how slowly the economy is growing, even a modest shock could do the trick.
To understand the risk, consider the historical behaviour of the unemployment rate. Looking at a three-month average, a remarkable pattern appears: When the rate rises, it moves either trivially or a lot. That is, either it goes up by less than a third of a percentage point, or it goes up by 2 percentage points or more and the US economy falls into recession. Since World War II, there has never been anything in between.
Why the gap? The answer probably lies in a dynamic that Yale economist Robert Shiller describes in his new book, “Narrative Economics.” Suppose some minor economic shock, such as heightened uncertainty about trade policy, precipitates modest job losses. When other workers hear that their acquaintances, or their acquaintances’ acquaintances, have been laid off, they worry that they could be next. So they tighten their belts a bit, eat out less, hold off on that kitchen remodeling. This reduces demand further and leads to more layoffs. Pretty soon the negative narrative is pervasive and self-reinforcing, with the unemployment rate rising persistently. The Fed can’t respond in time because definitive data take a while to appear, and because it takes time for monetary easing to stimulate economic activity.
There are plenty of identifiable risks that could trigger such a negative feedback loop right now. They include developments in the trade war between the US and China and the drag exerted by slowing global growth — along with people’s memories of the last deep recession, which could increase the power of gloomy narratives.
This danger bolsters the argument for the Fed to ease monetary policy at this week’s meeting of the Federal Open Market Committee. Such a preemptive move will reduce the chances that the economy will slow sufficiently to hit stall speed. Even if the insurance turns out to be unnecessary, the potential consequences aren’t bad. It just means that the economy will be stronger and the inflation rate
will likely move more quickly back towards the Fed’s 2% target.
—Bloomberg