The Most Important Least-Noticed Economic Event of the Decade
Sometimes the most important economic events announce themselves with huge front-page headlines, stock market collapses and frantic intervention by government officials.
Other times, a hard-to-explain confluence of forces has enormous economic implications, yet comes and goes without most people even being aware of it.
In 2015 and 2016, the United States experienced the second type of event.
There was a sharp slowdown in business investment, caused by an interrelated weakening in emerging markets, a drop in the price of oil and other commodities, and a run-up in the value of the dollar.
The pain was confined mostly to the energy and agricultural sectors and to the portions of the manufacturing economy that supply them with equipment. Overall economic growth slowed but remained in positive territory. The national unemployment rate kept falling. Anyone who didn’t work in energy, agriculture or manufacturing could be forgiven for not noticing it at all.
Yet understanding this slump — think of it as a mini-recession — is important in many ways.
It helps explains the economic growth spurt of the last two years. The end of the mini-recession in the spring of 2016 created a capital spending rebound that began in mid-2016, and it has contributed to speedier growth since. Oil prices have reached four-year highs, a major factor in a surge in business investment this year.
It helps explain some of the economic discontent evident in manufacturing-heavy areas during the 2016 elections. It offers warnings for where the next downturn might come from, and shows how important it is for policymakers to remain watchful and flexible about unpredictable shifts in the global economy.
Most important, the mini-recession of 2015-16 offers a cautionary tale for any policymaker who might want to think of the United States as an economic island.
The episode is stark evidence of the risk the Trump administration faces in threatening economic damage to negotiate leverage with other nations on trade and security. What happens overseas can return to American shores faster and more powerfully than once seemed possible.
How it happened
The mini-recession defies neatness. It’s a story of spillovers and feedback loops and unintended consequences. But here’s a summary:
In 2015, Chinese leaders were concerned that their economy was experiencing a credit bubble, and they began imposing policies to restrain growth. These worked too well and caused a steep slowdown. That in turn caused troubles in other emerging nations for whom China was a major customer.
Meanwhile, the Federal Reserve, finally growing confident that the United States economy was returning to health, made plans to end its era of ultra-easy monetary policy.
As the Fed moved toward tighter money, its counterparts at the European Central Bank and the Bank of Japan were going in the opposite direction. The prospect of higher interest rates in the United States and lower rates in the eurozone and Japan fueled a steep rise in the value of the dollar on global currency markets.
That in turn made China’s problems worse. China had long pegged the value of its currency to the dollar, so a stronger dollar was also making Chinese companies less competitive globally. When China attempted to reduce this burden by loosening the peg in August 2015, it faced capital outflows, making the economic situation worse.
Moreover, across major emerging markets, many companies and banks had borrowed money in dollars, so a stronger dollar made their debt burdens more onerous.
Put it all together, and when the Fed moved toward raising interest rates — as it eventually did in December 2015 — it was essentially making financial conditions tighter and therefore slowing growth across big swaths of the world.
The slowdown across emerging markets, in turn, meant less demand for oil and many other commodities. That helped cause their prices to fall. The price of a barrel of West Texas Intermediate crude oil fell to under $30 in February 2016 from around $106 in June 2014. The drops in the prices of metals like copper and aluminum, and agricultural products like corn and soybeans, were also steep.
That only heightened the economic pain for the many emerging economies that are major commodity producers, such as Brazil, Mexico and Indonesia.
Given falling prices and high debt loads among energy producers in the United States, the markets for stocks and riskier corporate bonds came under stress, especially in early 2016. That generated losses for investors and fears about the overall stability of the financial system.
Each of these forces has connections to the others. It wasn’t one problem, but an intersection of a bunch of them. That made it devilishly hard to diagnose, let alone to fix, even for the people whose job was to do just that.
The view from Washington
When Federal Reserve officials meet eight times a year to set interest rate policy, their job, assigned by Congress, is to figure out what is best for the United States economy. Their job isn’t to set a policy that will be best for China or Brazil or Indonesia.
Entering 2015, things were looking pretty good for the United States.
Inflation was below the 2 percent level the Fed aims for, but the traditional economic models on which the central bankers had long relied predicted that it would start to rise thanks to a rapidly falling unemployment rate.
Even when prices for oil and other commodities started falling in the middle of the year, the Fed’s models viewed it as a positive for the overall economy. Sure, some oil drillers and farmers might experience lower incomes, but consumers everywhere would enjoy cheaper gasoline and grocery bills.
Although officials spent a lot of time monitoring the global economy, the fact remained that the United States wasn’t as dependent on exports as many smaller countries. The 2008 financial crisis had shown how the American and European banking systems were deeply intertwined, but the same couldn’t be said of the ties with Chinese banks.
In other words, through the summer of 2015 it sure looked to many Fed officials as if the sound move was to start raising interest rates.
At the Treasury Department, which is responsible for the United States’ currency policies, it seemed well into 2015 that the strengthening dollar was mostly benign.
“There was a sense that the U.S. was doing well and the rest of the world was not doing very well,” said Nathan Sheets, a Treasury under secretary at the time and now chief economist at PGIM Fixed Income. “It was driven by strong U.S. fundamentals.”
But in late summer 2015, financial markets started to react more violently to the feedback loop of global currencies and commodities. It started to seem as if some of the old rules of thumb — about how a rising dollar or falling oil prices might affect the economy — might not apply.
Perhaps the economics models used by forecasters had become outdated, failing to fully account for the ways surging energy production had become more intertwined with the manufacturing sector and the financial markets.
“These things were all interconnected in different ways, and they all cycled back on the same industries and parts of the economy,” said Jay Shambaugh, a member of the Obama White House Council of Economic Advisers at the time. Still, distilling that complex story into crisp memos for senior officials was no easy task.
“You have to make memos short and to the point in the White House, and it was hard to say what exactly we thought was happening,” he said.
Behind closed doors at the Fed, officials started debating whether this outburst of volatility in markets really posed a risk to the overall economy. Should they stick to their plans to raise interest rates steadily, or slow down?
Over two days in October, the debate played out publicly.
Stan Fischer, the vice chairman of the Fed, was reluctant to adjust the planned rate increases, not wishing to let swings in financial markets dictate policy.
“We do not currently anticipate that the effects of these recent developments on the U.S. economy will prove to be large enough to have a significant effect on the path for policy,” he said in a speech in Lima, Peru, on Oct. 11, 2015.
Lael Brainard, a Federal Reserve governor who had worked on international issues at the Treasury, was quite a bit more worried.
“There is a risk that the intensification of international cross currents could weigh more heavily on U.S. demand directly, or that the anticipation of a sharper divergence in U.S. policy could impose restraint through additional tightening of financial conditions,” she said on Oct. 12 in Washington.
Ms. Brainard was right.
How the damage played out
The vicious circle of a stronger dollar, weaker emerging market growth and lower commodity prices caused spending on certain types of capital goods to plummet starting in mid-2015.
Spending on agricultural machinery in 2016 fell 38 percent from 2014 levels; for petroleum and natural gas structures — think oil drilling rigs — the number was down a whopping 60 percent.
The oil and gas exploration boom tied to fracking technology came to a halt with energy prices at rock-bottom levels, and with it sales of equipment tied to that boom.
With the fall in domestic capital investment in those industries and with weakness overseas, companies in related industries took it on the chin. Caterpillar, the maker of heavy equipment, had 30 percent lower revenue in 2016 than 2014.
In large segments of the economy, by contrast, it was business as usual. Business spending on investments like computers and office buildings kept rising, as did consumer spending.
Still, the industrial sector downturn was powerful enough to turn a strong expansion into a weak one. Overall growth fell to 1.3 percent in the four quarters ended in mid-2016, from 3.4 percent in the preceding year.
The national economy kept adding jobs. But Harris County, Tex., which encompasses energy-centric Houston and its near suburbs, shed 0.8 percent of its jobs in that span. In Peoria, Ill., hometown of Caterpillar, employment fell 3.2 percent.
In effect, this was a localized recession — severe in certain places, but concentrated enough that it did not throw the overall United States economy into contraction.
In Williston, N.D., where the economy had been booming for years because of a surge in oil and natural gas drilling on the Bakken oil patch, businesses of all types closed or slashed wages.
“It varies week to week, but every week keeps getting worse,” Marcus Jundt, owner of a restaurant, the Williston Brewing Company, told CNBC in March 2016. “We don’t know where the bottom is, but we’re not there yet.”
But it could have been worse.
How it ended
When Janet Yellen assumed leadership of the Federal Reserve in early 2014, she inherited an economy that had been expanding steadily for years, with a great deal of help from the Fed’s interest rate policies.
Deciding how and when to pull that support — when to raise interest rates, which had been near zero for more than six years — was set to be the defining choice of her tenure.
In 2015, with signs that the United States economy was returning to health, she and her colleagues believed it was time to begin raising interest rates. She is a leading labor market scholar who spent a career studying, among other things, how a tight labor market can eventually feed through to inflation.
In July of that year, with stirrings of the emerging markets disruption, the unemployment rate was 5.2 percent, not much above the level Fed officials believed was consistent with a fully healthy labor market. Then the turmoil of August began.
Ms. Yellen elected not to raise rates in September, waiting for more evidence that the economy was truly on track and that the emerging market troubles wouldn’t do too much damage to the domestic economy. But by December she judged that the situation had stabilized enough to raise rates.
At the same time, the Fed revealed forecasts indicating that its senior officials expected to raise interest rates four more times in 2016. Within weeks, global markets were sending a message: Not so fast.
The dollar kept strengthening, the price of commodities kept falling, and the Standard & Poor’s 500 dropped about 9 percent over three weeks in late January and early February. Bond yields plummeted, suggesting that the United States was at risk of recession.
In mid-February 2016, the financial leaders of the world’s most powerful nations were set to convene in a Shanghai for the periodic G20 summit. With global markets in turmoil, the great question was: Can the officials rein in these forces?
The official statement released by the participants in the summit contained multiple nods to the turbulence, acknowledging risks from “volatile capital flows” and falling commodity prices. But more important than any words was what followed in the following weeks.
Two days after the summit, China lowered its reserve requirement on banks, essentially opening the spigot for more lending. In the months that followed, it would put in tighter controls on the movement of capital outside the country, and seek to tie the value of the yuan less closely to the dollar.
Three weeks after the summit, the Fed had another policy meeting. Rather than raise interest rates further as had been envisioned in December, Fed officials declined to raise rates — and steeply reduced their expectations of how much further they would raise rates over the remainder of 2016.
Together, these steps were enough to end the vicious cycle. The dollar stopped appreciating and started dropping. Oil prices bottomed out and began a recovery. In the United States, capital spending was growing again by the summer of 2016.
What really happened in Shanghai?
Some analysts of financial markets have put a conspiratorial bent on the concerted action from the two sides of the Pacific, speculating that leaders had made a secret deal at the G20 meeting in February 2016. They call it the “Shanghai Accord”— essentially, that the Fed would hold off on rate increases if the Chinese also took actions of their own.
Ms. Yellen said it’s not so. She said in an interview that there was an extensive exchange of views and information with the Chinese delegation in Shanghai, but that there were no promises or explicit agreements.
“I realize it looked to much of the world like some kind of secret handshake deal,” she said. “This wasn’t a deal. This was the global economy and capital markets affecting the U.S. outlook, and the Fed being sensitive to that, taking that into account and its influencing policy appropriately.”
The Fed, she said, did what it thought was best for the United States economy without knowing exactly what the Chinese would do.
Mr. Sheets, the former Treasury official, also dismissed the idea of some secret agreement.
“It’s just not how it works,” he said. “There were a lot of meetings. A lot of bilaterals and quadrilaterals. You meet with your counterparts and talk about the global economy and think about the challenges and what might be done. But there was nothing agreed behind closed doors that was not part of the formal statement.”
Even if there was no formal secret agreement, the result — leaders of the world’s two biggest economies squarely focused on the risks that the situation presented — turned out to be enough.
The impact of the global commodity-currency spiral of 2015-16 is evident from a glance at the economic statistics. It is less so in the economic debates of 2018.
First, while the Trump administration has claimed full credit for a surge in business investment, the bounce-back from the mini-recession is a major factor.
White House economists have presented charts showing a surge starting in the fourth quarter of 2016, when the election took place. But that turnaround began in mid-2016 by most measures, not late 2016 as suggested by the White House’s “six quarter compound annual growth rate” measure.
Second, the mini-recession might well have affected some political attitudes during the 2016 election. While the economy was in pretty good shape for people in large cities on the coasts, 2016 was rough for a lot of people in local economies heavily reliant on drilling, mining, farming or making the machines that support those industries.
A poll in October 2016 by an agriculture trade publication, Agri-Pulse, found that 86 percent of farmers were dissatisfied with the way things were going in the United States.
Third, economic policymakers need to display the flexibility to respond to incoming information, even when it doesn’t fit their own forecasts or preconceptions.
If Ms. Yellen had been more stubborn about sticking to the plan to keep raising rates through 2016 because of her training as a labor market economist, the result might well have been an actual recession. “She’s always learning,” said Julia Coronado, president of MacroPolicy Perspectives, “and not so egotistical that she’s wedded to one view of the world.”
Finally, it shows the global economy is so interconnected that events in Shanghai or São Paulo can cause unpredictable effects in faraway places.
In the last year, the Trump administration has been lobbing tariffs at China and other major economic partners to extract more advantageous terms for trade. But the mini-recession warns of the risk of ricochet.
Like it or not, the complexity of our global connections means that policy can’t just focus on the home front. In 2016, we learned that lesson the hard way, even if not everybody was paying attention.