The Economic Outlook: Four Questions to Consider

By Thomas Hoenig, Distinguished Senior Fellow, Mercatus Center

Introduction

Economic forecasting is a hazardous undertaking. Consider, for example, that the Federal Open Market Committee (Fed) forecasted just over a year ago, that the appropriate Federal Funds Rate would be less than 1 percent at the end of 2022. When the Fed made that rate forecast, it claimed inflation was due to temporary supply disruptions that would self-correct. It gave far less weight to the significant increase in aggregate demand that it had helped create. In June of last year CPI inflation reached a forty year high of 9 percent; however, having raised rates aggressively since then, the Fed is forecasting that inflation will return to its 2 percent target next year, and that while the economy will slow, there will be no recession. This is an attractive forecast, but is it really the most likely?

In what follows, I will frame a somewhat different economic outlook around four questions:

1. What caused CPI inflation to rise to an historic 9 percent annual rate in June of 2022?
2. Will the Fed reestablish price stability as defined by its 2 percent inflation target?
3. Will the Fed trigger a recession?
4. What policy risks lie ahead?

Question 1: What caused CPI inflation to rise to an historic 9 percent?

This question has been discussed extensively, but it is fundamental to addressing the outlook. The pandemic was the trigger to a tragic economic upheaval. However, the pandemic was only one factor contributing to inflation.

The pandemic reduced economic output — aggregate supply. It put people out of work, it disrupted global supply and multiplied the emerging effects of global trade frictions. These market disruptions and accompanying recession were brutal for the American public.

Rather than allow this to continue unabated, the government and Fed, initiated the most expansionary spending and money creation processes witnessed in the U.S. outside of a wartime environment; and it did so for a period well beyond the pandemic crisis. The government increased its spending from $4.4 trillion in 2019 to above $6.5 trillion, a 50 percent increase, in each year 2020 through 2022. Today with the recently passed omnibus bill, government spending will again exceed the $6 trillion dollar mark.

During the 2020 through 2021 most of the additional spending went directly to businesses and consumers. The Fed estimates government programs not only sustained private spending but led to an excess of personal savings (the amount above historic averages) by $2.5 trillion. Also, the money for this spending was nearly all borrowed as the government did not increase taxes, and its debt expanded from $22.5 trillion in 2019 to over $31 trillion now.

If the government borrows to spend, it historically does so from the private sector or other external sources, which reduces private demand. However, increasingly the government borrows from the Fed, which literally creates the dollars to purchase debt. For example, the Fed’s balance sheet increased from less than $4 trillion in 2019 to nearly $9 trillion today (up from $900 billion in 2007). The Fed also kept interest rates near zero, further stimulating demand through greater business leverage. As a result, money growth in the U.S. between 2019 and March of 2022, increased at an annual rate of more than 20 percent.

These policies helped increase aggregate demand above that destroyed during the pandemic. There was little chance that the recovery of supply channels and increases in productivity could satisfy this excess demand. In its simplest form, there was too much money chasing too few goods and services. Without timely actions on the part of the government and the Fed, inflation was inevitable; and there was no timely action.

U.S. CPI inflation increased from less than 2 percent prior to the pandemic to above 9 percent in June of 2022, and as just reported for December it was still 6.1 percent higher than a year ago. Real estate also experienced serious inflation where, for example, shelter inflation rose from 4 percent in January 2022 to 7.5 percent by year end.

Question II: Will the Fed Reestablish Price Stability?

The Fed can reestablish price stability, defined as a 2 percent annual inflation rate, but it won’t be easy or quick. The Fed is using two tools to do this. First, it is increasing interest rates; second, and less discussed, it is shrinking its balance sheet at a rate of $95 billion per month.

The Fed has increased its policy rate, the fed funds rate, from near zero a year ago, to near 4.25 percent currently, and it will likely be 5 percent or higher in the first half of this year. As intended, the U.S. economy is slowing. Interest sensitive sectors experienced its effects early. U.S. residential real estate prices have declined 10 consecutive months. Housing starts fell from a high of over 1.8 million units in April to 1.4 million units during December of last year. Also, commercial real estate is slowing as it confronts higher interest rates, soaring prices of materials, and accelerating wage costs. Other growth industries, tech for example, are also suffering as rates have an inevitable slowing effect on income growth and cash flow.

The second force slowing the economy is the Fed’s action to reduce the size of its balance sheet. As it does this, it reduces bank reserves and, therefore, market liquidity and bank lending, which adds to the effects of rising rates. While the reduction in reserves may seem moderate given the overall level, it is a reduction in reserves of above a trillion dollars annually.

These actions are having the intended effect. As of this past December, the CPI year-over-year inflation rate declined from 9 percent in June to 6.1 percent in December.

However, the Fed isn’t ready to declare victory. It keeps reminding the world that labor demand remains exceptionally strong and wage demands are putting upward pressure on prices. Also, the inflation experienced over the past year has found its way into core measures of inflation, which removes food and energy, and has fallen less rapidly than overall inflation.

Also muddying the water is the federal government’s spending and borrowing. Its spending remains above $6 trillion, adding to aggregate demand. It is also projecting annual deficits of over a trillion dollar well into the future. This spending and borrowing put the burden of solving inflation more directly on the Fed rather than Congress. It also makes the Fed the villain, should the economy fall into recession.

The Fed understands its predicament and the pressure that will build for it to fund future deficits at lower rates. But it insists that it will raise rates until it is certain that excess demand is brought into balance with the economy’s growth potential and that inflation is checked. Jay Powell, the Chairman of the Fed, says he is taking a Volcker-like approach in addressing this inflation. For those who know the effects on the economy of Volcker’s policy, Powell is saying the Fed will risk a serious recession rather than see inflation reignite in 2023 and beyond.

Question III: Will the Fed Trigger a Recession?

While the Fed suggests it will accept a recession, it is not projecting a recession. It is projecting an economic slowdown in which GDP growth falls to a .5 percent annual rate in 2023, strengthening further in 2024 and 2025. This is a plausible outcome. Unemployment, for example, remains low at 3.5 percent despite the economic slowdown. Ten million jobs are available to those qualified and only 6 million job seekers. As the economy slows, jobs losses may show up to some extent in fewer posted job openings and less in unemployed individuals. If so, the unemployment rate may not increase much above 5 percent. Thus, the shortage in available labor may provide the needed cushion for the labor market.

The economy is also benefiting from an expanding energy industry and lower energy prices. There also appears to be a shortage of housing, ready to recover when rates settle to a lower, stable rate. Lastly, as the pandemic recedes and demand recovers, consumers should return to in-store buying, which would improve the outlook for retail space.

These serendipitous economic conditions, however, are being offset by other events that may require the Fed to push rates higher for longer. Average hourly earnings were up 4.6 percent in December over the previous year. While this is down from a year ago, labor is still suffering a loss of real income and is feeling the pinch. The rail industry, airlines and some major manufacturers recently have been reminded that labor wants a greater share of the income pie. For labor to accept slower wage increases forward, it must be convinced that stable prices have returned, and that may take a recession and higher unemployment.

For these reasons, the Fed appears insistent on raising rates from 4.25 percent to 5 percent or higher over the next half year. It has allowed the yield curve to become and remain inverted, which signals a recession ahead. With its declining balance sheet and reserves, deposits and loanable funds are less abundant (liquidity constrained). Such policies, if they continue, cannot help but make the banking industry more vulnerable, more cautions in its lending and, therefore, lead to slower growth.

Also, the consumer is spending its excess savings, consumer debt has increased, both of which suggest reduced spending ahead. Finally, trade frictions are not receding, and the rest of the world’s economies are slowing and less a source of growth for the U.S. A global conflict remains a concern. All these factors add to economic uncertainty and impinge on economic growth.

Sorting through these differing trends, it seems more likely than not that the U.S. will experience a recession in 2023. While the Fed is projecting .5 percent growth in 2023, it is adamant that its priority is 2 percent inflation, suggesting it will accept a recession. How bad might the recession be is unknown. It depends importantly on government and Fed policy choices that have yet to be made.

Question 4: What policy risks lie ahead?

Should a recession take hold, business bankruptcies and bank loan losses will increase, and unemployment will rise to 5 percent or higher, and CPI inflation will decline more quickly toward the 2 percent target. Also, and importantly, the Fed will be anxious to reverse its stance. As inflation and wage increases decline in late 2023 or early 2024, the Fed will begin discussions about when to lower its fed funds rate from its peak rate toward what might be considered a longer-term equilibrium Fed funds rate, perhaps 2 to 2.5 percent. The discussions will include the level but also how quickly rate changes should come, and this presents at least two notable risks to future policy decisions.

The first risk concerns how the Fed will react to the political and public pressure that comes with the recession. The Fed says repeatedly that it is committed to its policy. However, as the economy slows and unemployment increases, politicians, Wall Street, and the public will press the Fed relentlessly to ease policy, even if inflation slows only modestly. This risk will be more acute the more GDP falls and unemployment rises. This was the pattern in the 1970s, which led to the repeated episodes of inflation then recession until inflation reached nearly 14 percent, and the Fed was compelled to raise rates to 20 percent. This action finally broke the inflation cycle but at a terrible price in lost growth, unemployment, and lower income across the economy.

This is no small risk. Over the past 2 ½ decades the Fed as moved beyond just managing interest rates. It has added a new tool to its policy kit. If, for whatever reason, the economy slows, falls into a recession, or experiences a financial crisis, the Fed not only lowers interest rates, but injects substantial excess liquidity into the system to stabilize markets. Examples of such actions include the late 90s in response to the Asian and Russian financial crisis, the dotcom bubble and 9/11 shock. It took the policy to a new level following the Great Recession — calling it quantitative easing, or QE. It relied on QE during the repo liquidity shock of 2019, and most recently the pandemic. As a result, its balance sheet has increased from less than a trillion dollars as late as 2008 to 9 trillion dollars at the end of 2022. QE and interest rates both are now the principal tools of monetary policy, used lavishly when trouble threatens, and Wall Street and Congress have come to expect this from the Fed.

The second risk is that the Fed is aware of the market’s skepticism of its resolve. To regain credibility, it has messaged that it will accept a recession to assure the return to 2 percent inflation. Unfortunately, it cannot know for certain what policy calibration will achieve its goal. In its zeal to remain firm, it may raise rates too high or keep rates elevated too long, worsening consumer confidence, as it slows the economy. Inflation may decline more quickly toward 2 percent but at a cost of slower growth, loss of jobs and income. At that point the Fed would find itself struggling to regain control of its policy and the economy.

Complicating these risks are a host of external factors that will affect the U.S. and global economy making the policy choice increasingly risk prone. The Federal debt continues to grow, and the Fed will be pressured to provide the liquidity to fund it. Trade friction remains an issue and other supply bottlenecks make judging the source of inflation difficult. The Fed must manage policy around these risks and find a path back toward 2 percent with minimal damage to the U.S. economy.

It will be a difficult task for the Fed to work through these challenges and risks. It might succeed but it will be a very bumpy policy ride.

Summary

Boiling this outlook down to its essence: the Fed knows it must slow the economy to bring inflation to 2 percent, and it is doing so. It expects it will be successful and avoid a recession. However, it is just as likely that the economy will suffer a recession and if so, it is better to suffer a moderate one now than a more severe one later with all its more costly effects. The Fed’s goal is to calibrate the funds rate lower, perhaps 2.5 to 3.0 percent, a level it may conclude is consistent with low inflation, low unemployment, and stable long run growth Finally, the Fed must balance its policy between being too timid and too aggressive. Its track record is sketchy. Maybe this time will be different.