Also, there is one area of vulnerability that could exacerbate any downturn: corporate debt. During this expansion, companies have levered up, borrowing money to buy back shares and deliberately allowing their credit ratings to decline. As a result, there has been a huge increase in the amount of debt rated “BBB,” a significant portion of which could drop into junk territory when the next recession hits. A big increase in the amount of junk bonds could cause indigestion as this market is small relative to the size of the investment-grade debt market. This could lead to a credit crunch that would exacerbate these companies’ troubles.
Also, the Tax Cuts and Jobs Act made the U.S. economy more vulnerable in two important ways. First, companies that lose money in a downturn can no longer get refunds against their prior years’ tax payments. Second, the legislation imposes limits on the deductibility of interest. As earnings fall, such constraints become more binding.
Despite these issues, I don’t expect the next recession, whenever it does come, to be anywhere near as harsh as the last one. Downturns associated with financial crises tend to be particularly painful, and I believe the United States has done enough to prevent a repeat of the 2008 disaster. Hence, the country is more likely to experience a garden-variety slump, which the Fed should be capable of handling. Even if the central bank has less scope for rate cuts should the federal funds rate peak at 3 percent or less, it has plenty of other tools — such as forward guidance and quantitative easing — to stimulate the economy should that become necessary. And, the rise in the nation’s indebtedness does not rule out the use of fiscal policy stimulus.
This article was provided by Bloomberg News.