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8 2 The Baseline Forecast Calls for Late-Stage Expansion in 2020 (60percent probability) If the trade war does not escalate further and does not become even more chaotic, then there is a 60 percent probability that the late-stage U.S. economic expansion continues through 2020. Nonetheless, even without further escalation, the trade war has done considerable damage to the U.S. economy and its prospects for economic growth. The pace of 2020 GDP growth will slow markedly – from 2.3 percent growth in 2019 to 1.5 percent in 2020. Consumer spending will contribute the most to U.S. GDP growth, but government spending also will contribute to GDP growth. Monetary policy will be supportive of growth, but there are limits to what the Federal Reserve can do to offset trade tensions and other risks. Due to extremely low mortgage rates, rising rents, and demographic trends – a higher rate of household formation – housing sales and starts will move higher in 2020. Unless there is a resolution – or a major lessening – of trade tensions, industrial production will decrease. Manufacturing will be in recession. In 2020, overall job growth will be marginally positive, but some important industry sectors will shed jobs, including manufacturing, retailing, and information. Heightened uncertainty and slower top line growth will cause net hiring to slow very dramatically – from 1.5 percent in 2019 to 0.8 percent in 2020. The slower pace of job growth will cause the U.S. unemployment rate to rise slightly from 3.7 percent in 2019 to 3.8 percent in 2020. The main reasons why job growth will slow and struggle to remain positive are: (1) tariffs and trade tensions, (2) lower confidence on the part of both businesses and consumers, (3) lower business investment, (4) less support from the 2018 federal tax cuts, (5) negative – or much smaller – wealth effects, and a slowing global economy. Due to labor market tightness, the slowdown in personal income growth will not be as extreme as the slowdown in GDP growth, but nervous households will save a slightly higher proportion of their income in 2020 than in recent years. The combination of slower income growth, a higher savings rate out of current income, and less confidence will cause consumer spending to grow more slowly in 2020 than in 2019. Consumers will support GDP growth, but not to the same extent as in they did in 2019. Due to lower equity prices, household wealth is more likely to decrease than to increase in 2020. Nonetheless, home price appreciation will offset much of the wealth lost in the stock market. The personal savings rate will rise from 8 percent in 2019 to 8.2 percent in 2020. That is a weak headwind for the U.S. consumer sector. Nonetheless, for this late in the business cycle, households' balance sheets are in very good shape. Across all businesses, corporate balance sheets are not as strong as a few years ago but should be manageable as long as interest rates do not increase very quickly, an extremely unlikely prospect. Even so, it is somewhat worrisome that many highly leveraged large businesses have taken on considerable debt. These leveraged loans typically have floating interest rates. Highly leveraged companies therefore are vulnerable to interest rate shock, but, again, that seems unlikely in 2020. Small businesses' finances are in comparatively good shape. Small business lending should expand in 2020. Put it all together, the credit markets should be supportive of growth. Credit will increase in 2020, but more slowly than in recent years. Recent rapid growth in lending to highly leveraged businesses represents a risk to the U.S. economic expansion. Because interest rates are low and are more likely to fall than to rise in 2020, leveraged lending to businesses is very unlikely to trigger a recession in the coming year, but it will exacerbate a recession triggered by another factor (e.g., a trade war or oil price shock). A related risk is the size of the junk corporate bond market. Excessive risk-taking took place in these two areas of the financial system. However, unless interest rates rise substantially it will not trigger a 2020 recession. In March 2019, the spread between the three-month T-bill and the 10-year notes inverted. In August 2019, the spread between the two-year and 10-year notes inverted. The 2019 inversions signal that the odds of recession in 2020 are high. An inversion of the yield curve occurs when short-term interest rates exceed long-term interest rates. An inversion does not cause a recession, but it suggests that monetary policy is too tight given market participants' expectations for growth. Historically, a yield curve inversion is a good indicator that a recession will begin within the next six to 18 months. In modern economic times, yield curve inversions preceded all U.S. recessions, but not all inverted yield curves have led to a recession. False signals are rare, but not without precedent. For example, there was a false signal in 1998. The classic explanation for an inversion of the yield curve is that investors pile into long-term bonds because they believe that economic prospects will be better in the long-term than in the near-term. The increased demand for long-term

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