Preparing for the Next Macroeconomic Cycle — and Its Risks

When the pandemic hit last year, business leaders’ time horizons contracted sharply, forcing their focus on issues of survival, adaptation, and resilience.

With a better than expected recovery ongoing, horizons are expanding again. Yet rather than looking at just the recovery or the year ahead, this is a good time for leaders to think about the next economic cycle in its entirety.

The Life Cycle of an Expansion

The life cycle of an expansion is best viewed through the lens of the labor market. In the so-called “young” stage of the expansion, high unemployment from the preceding recession fuels the expansion. But once labor markets tighten, the cycle enters the “old” stage with fundamentally different characteristics: Hiring is more difficult, growth is scarcer, and vulnerabilities, such as inflation or bubbles, are larger.

In the early innings of the post-Covid cycle, we can see that it is on a truly unique path to looking old at a young age. As shown in the below chart, elevated levels of unemployment typically point to many years of expansion before the labor market turns tight, but the post-Covid path has a much steeper slope. When exactly the post-Covid expansion will cross into a tight labor market is unknown, but the U.S. economy is generally thought to be tight at an unemployment rate of around 4.5%. Getting there from current levels of 6.3% could happen before the end of 2022.

That said, reaching the older stage of an expansion is not a sign of risk on its own. Rather the risks arise from the cycle’s longevity, when there is time for pressures to build into macroeconomic imbalances, particularly when policy pushes for more growth.

A Lengthy Post-Covid Expansion?

A confluence of three drivers makes the post-Covid cycle resilient and thus predisposed to be long lived:

• The rise of services: It may seem counterintuitive that services help longevity given that Covid is mostly a services recession. Yet lockdowns and social distancing are unique to the Covid shock and outside of a pandemic, services are far less volatile than physical goods consumption. The fact that services have gradually displaced physical production has already strengthened cyclical resilience. Consider the fracking bust of 2015, which could have ended other post-war cycles. While it sent the energy sector into recession, it was not big enough, relative to the economy, to derail the expansion.
• Easy monetary policy: Classically when cycles turn tight, they become vulnerable to aggressive rate hikes to prevent overheating. Today, not only does well-anchored inflation enable policy makers to move very slowly, but too low inflation has compelled them to keep rates low until inflation actually moves above their target. This makes it less likely that rate hikes end the cycle and gives ample room to provide stimulus aiding longevity and imbalances.
• Aggressive fiscal policy: Unlike monetary policy, fiscal policy is politically controlled and is mostly guided by the instinct to extend the expansion. What will be different going forward is a more daring policy culture, plausibly fueled by the Covid stimulus experience, where aggressive stimulus is more accepted, assisting cycle longevity and imbalances.

The consequence of longevity, particularly when it plays out in the mature stage of the cycle, is the building of two different types of imbalances — inflation and bubbles, both of which are hard to navigate.

Understanding Inflation Risks

In many ways, the popular and persistent fear of inflation is surprising, given the 30-plus year inflation downtrend in the U.S. and other economies. Yet, a lengthy expansion could increase various inflation risks, including:

• Transitory inflation: Current fears about imminent inflation don’t qualify as risks since these spikes will be temporary. Year-over-year inflation will spike in March and April, given that the same months last year capture the height of the pandemic demand shock when prices were particularly weak. This should and will be ignored by policy makers and markets.
• Non-recessionary containment of inflation: Sustained tight labor markets eventually lead to price pressures, which could lead to inflation. Monetary policy makers will strive to respond, effectively allowing pressure to ease and the cycle to continue (the much sought after “soft landing”).
• Recessionary containment of inflation: Those same inflation pressures may also be too strong for policy makers to manage, leading to policy tightening that introduces a recession. While plausible, this is not likely, given well-anchored inflation and the ability for policy to move slowly while still having impact.
• Inflation regime break: Inflation that is uncontrolled by policy — or even encouraged by further policy stimulus — has the potential to undermine the well-anchored inflation regime. This is possible, but not plausible, particularly in the short run as it takes years of sustained tightness and policy disregard to trigger a regime break.

There is additional risk from policy makers needing to manage market expectations. Such expectations have assumed easy monetary policy for many years to come and pivoting to a faster rise in rates might be difficult to execute without creating market turbulence.

Understanding Bubble Risks

Bubbles pose a more significant risk to the economic cycle as they can emerge quickly and are more difficult for policy makers to manage: Remember that bubbles (dot-com and housing) have been a key to ending two of the last three cycles. Additionally, they can manifest in a variety of forms (valuation, quality, quantity, and velocity), but they do not have to end problematically — making choices about their management even more challenging.

Yet, long-lived, tight cycles create fertile ground for bubble formation, particularly when aided by easy monetary policy. Consider the different ways in which bubbles can escalate and their impact:

• Product bubbles are narrow — operating in a single or small collection of markets. While they may be dramatic and challenging for business engaged in those markets, they are of limited consequences for those not in these markets and for the macroeconomy. An example is the Beanie Babies craze of the late 1990s, when the $5 stuffed toy saw secondary market prices of $1,000 and more.
• Cross-sectional bubbles feed off the initial bubble and are more consequential as they build a cascade of effects on the financial and real economies. While inherently more threatening to the macroeconomy, not all end badly, as some are rooted in fundamentals. Consider today’s low interest rates which, while exceptionally low, are also likely to remain historically low (even if somewhat higher than in 2020) for some time. Their rise does not need to be problematic.
• Cycle-ending bubbles are likely to be cross-sectional ones reaching such a size that when they are unwound, it creates real or financial headwinds ending the expansion. The dot-com bubble ending the 1990s expansion and the housing bubble ending the 2000s expansion are recent examples.
• Systemically relevant bubbles not only end cycles, they create policy challenges that go unmet — either from an unwillingness or inability of policymakers, both of which remain unlikely from today’s perspective. These bubbles break the economic regime and leave an extraordinary footprint on society, such as the 1920s stock market bubble and the Great Depression.

How Leaders Can Prepare

Unlike Covid, which was an exogenous shock and thus largely unpredictable, the imbalances and risks discussed above are endogenous to the system — they arise from within and grow over time. That means leaders have a chance to build awareness, monitor, and grow their resilience to such shocks, even if precise predictions will remain out of reach.

Some of the actions leaders can take to improve resilience to the cyclical risks discussed include:

• Building the risk monitoring, analytic capabilities, and scenario planning required to track and understand risks
• Retaining flexibility even while making expansionary investments, in order to build resilience against later reversals
• Pressure testing strategies and plans to discover hidden vulnerabilities
• Prioritizing, managing and measuring resilience as explicitly as firms do efficiency, while being realistic about the tradeoffs
• Building a culture that enables intellectual openness and ability to entertain and implement a contrarian strategy when the need arises

While we cannot predict the next cycle with precision, we can know some of its overall contours, and the risks and opportunities arising from them. Far-sighted leaders can put these to work to minimize the risk of their expansionary strategies derailing further down the line.