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Pressure will be on the Fed to clean up Trump’s trade war mess

Our economy is at a critical juncture. Recession risks are the highest they have been since the record-long economic expansion began over a decade ago. Whether we suffer a downturn will greatly depend on how much longer President Trump pursues his trade war with China. Whether we avoid a recession will greatly depend on the Federal Reserve.

Manufacturing and agriculture are arguably already in recession. Industrial production and farm incomes are flagging. The transportation and distribution industries are also struggling since they move much of what factories and farmers produce. Combined, these activities account for no more than one-fifth of the nation’s GDP, but as long as they are contracting, the broader economy will remain vulnerable to anything else that may go wrong.

Investors are anxious that something will. Based on a handful of stock and bond market indicators — typically prescient barometers of future recession — we estimate that the odds of a recession by this time next year are better than even.

The predominant threat to the business cycle is President Trump’s trade war with China. Geopolitics are also unusually unsettled, from the possibility of a no-deal Brexit to heated political unrest in Hong Kong to mounting conflict in the Middle East that could disrupt global oil supply. Whether this expansion continues for very long depends on how these events play out, and how the Federal Reserve and other global central banks respond.

The Fed will be instrumental to whether the economy is able to navigate through the next year without suffering a recession. It is already on the case, cutting rates for the third time this year on Wednesday, putting the federal funds rate, the rate the Fed controls, between 1.5% and 1.75%. This will provide much-needed support to the economy.

However, if President Trump escalates his trade war or there is a no-deal Brexit or any of a number of other geopolitical hotspots boils over, the Fed will be overwhelmed. It will quickly be back to dealing with the zero lower bound — when interest rates are close to zero — quantitative easing and even negative interest rates. With the federal funds rate and 10-year Treasury yields already hovering below 2%, any of these shocks would likely quickly push rates into negative territory. For context, in typical recessions the Fed has lowered the federal funds rate by close to 5 percentage points.

Even if the Fed wanted to respect the zero lower bound on the federal funds rate, it probably couldn’t, since the yield curve would deeply invert as long-term interest rates turn more negative. Foreign capital would pour into the United States because rates would likely go even more negative in Europe and Japan, as their economies are substantially weaker than ours’. Negative rates would be hard on the financial industry’s profitability, because it would be losing money on the loans they make. An inverted yield curve with short-term rates pinned at the zero lower bound would be untenable for the system, further undermining the availability of credit and the economy.

And if the experience with negative rates in Europe and Japan is any guide, they will do little to support the economy. There is mounting evidence that negative rates undermine investor and business confidence, since they signal how dysfunctional the economy is. Moreover, negative rates in the United States would have serious implications for the huge shadow financial system that provides about half the nation’s credit. The non-banks that make up this system — including fintechs, hedge funds, private equity firms — rely on lines of credit from large banks and short-term funding markets for the liquidity they need to support their lending activities. It is unclear what would happen to this liquidity in a world of negative rates.

President Trump has recently dialed back the rhetoric in his trade war with China. This has buoyed global stock markets, as widespread expectations, including mine, are that the president will soon come to terms with China. Not that this means the higher tariffs he has imposed on Chinese goods will lift or that there will be substantive changes to Chinese behavior around trade, access to their markets or intellectual property protection. But it does mean there won’t be an escalation in the trade war. And while uncertainty will continue to weigh on business investment and hiring — and thus the economy’s growth — recession will remain at bay.

Of course, we have been at this same place more than once in the past year only to see the negotiations break down and the president double down on his tariffs and threaten retaliation. If the same happens this time, investors are sure to lose faith and financial markets and economic growth will be roiled.

To be clear, recession is not imminent, at least not in the United States. Although growth has throttled way down from last year, the economy is still growing just below its 2% GDP growth potential. Underlying job growth — abstracting from the near-term vagaries and upcoming revisions to the jobs data — is likely near 100,000 per month. At this pace, unemployment will remain stable. However, if growth slows any further, which it will if the president can’t figure out a way to stand down on his trade war with China, unemployment will begin to rise. Once that happens, recession will be upon us regardless of the preventative measures the Fed is taking now to prevent one.

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