From Tim Wallace at The Age:
Nine years on from the start of the financial crisis, the US recovery may be overheating, Legal & General Investment Management economist James Carrick has warned.
He has predicted a series of interest rate hikes will tip the US into a 2018 recession.”Every recession in the US has been caused by a tightening of credit conditions,” he said, noting inflation is on the rise and the US Federal Reserve is discussing plans for higher interest rates.
Officials at the Fed have only raised interest rates cautiously, because inflation has not taken off, so they do not believe the Fed needs to take the heat out of the economy.
But economists fear the strong dollar and low global commodity prices have restricted inflation and disguised domestic price rises. Underneath this, they fear the economy is already overheating.
As a result, they expect inflation to pick up sharply this year, forcing more rapid interest rate hikes.
That could cause a recession next year, they say. In their models, the signals are that this could take place in mid-2018.
I agree that most recessions are caused by tighter monetary policy from the Fed but the mid-2018 timing will depend on hourly earnings rates.
Hourly earnings are a good indicator of underlying inflationary pressure and a sharp rise is likely to attract a response from the Fed. The chart below shows how the Fed slams on the brakes whenever average hourly earning rates grow above 3.0 percent. Each surge in hourly earnings is matched by a dip in the currency growth rate as the Fed tightens the supply of money to slow the economy and reduce inflationary pressure.
Two anomalies on the above chart warrant explanation. First, is the sharp upward spike in currency growth in 1999/2000 when the Fed reacted to the LTCM crisis with monetary stimulus despite high inflationary pressures. Second, is the sharp dip in 2010 when the Fed took its foot off the gas pedal too soon after the financial crisis of 2008/2009, mistaking it for a regular recession.
Hourly earnings growth has risen to 2.5 percent but the Fed is only likely to react with tighter monetary policy when earnings growth reaches 3.0 percent. Recent rate rises are more about normalizing interest rates and are no cause for alarm.
I am more concerned about the impact that rising employment costs will have on corporate earnings.
The chart below is one of my favorites and shows the relationship between employee compensation and corporate profits (after tax) as a percentage of net value added. Profit margins rise when employment costs fall, and fall when employment costs rise.
Employee compensation is clearly rising and corporate profits falling as a percentage of net value added. If this trend continues in 2017 (last available data is Q3 2016) then corporate earnings are likely to come under pressure and stock prices fall.