The recession America expected never happened.
Many economists have spent the start of 2023 predicting a painful slowdown, a view so widely held that some commentators have begun to Treat it ace given. Inflation had reached its highest level in decades, and many forecasters believed that this would require a decline in demand and a prolonged rise in unemployment to combat this.
Instead, the economy grew 3.1% last year, up from less than 1% in 2022 and faster than the average of the five years before the pandemic. Inflation has fallen considerably. Unemployment remains at an all-time low and consumers continue to spend even with the Federal Reserve’s interest rates at their highest level in 22 years.
The gap between apocalyptic predictions and the reality of the climax is forcing Wall Street and academia to reckon. Why did economists get it so wrong, and what can policymakers learn from these mistakes as they try to anticipate what might happen next?
It is too early to draw definitive conclusions. The economy could slow further as two years of Fed rate hikes begin to add up. But what is clear is that old models of growth and inflation have not served as accurate guides. Bad luck contributed more to the initial inflationary surge than some economists imagined. Luck helped bring it down again, and other surprises came along the way.
“It’s not like we fully understood macroeconomics before, and it was a pretty unique time,” said Jason Furman, a Harvard economist and former Obama administration economic official who thought the drop in inflation would require an increase in unemployment. “Economists can learn a great and healthy dose of humility. »
Economists, of course, have a long history of getting their predictions wrong. Few expected the global financial crisis at the start of this century, even when the mortgage meltdown that triggered it was well underway.
However, the recent failures have been particularly significant. First, many economists have discounted the possibility of rapid inflation. When prices took off, Fed economists and professional forecasters widely anticipated at least a brief period of contraction and a slight increase in unemployment. Neither has come to fruition, at least so far.
“It has always been difficult to predict what an economy emerging from an unprecedented pandemic would look like,” said Matthew Luzzetti, chief economist at Deutsche Bank, whose team last year predicted an overly pessimistic recession.
Not all economists expected a recession last year. Some rightly expected inflation to fall as pandemic-related disruptions eased. But even most of them were surprised by how little damage the Fed’s rate-raising campaign appears to have done.
“The unemployment rate hasn’t even increased since the Fed started tightening,” said Alan S. Blinder, a Princeton economist who served as Fed vice chairman during the last successful soft landing. and who has been an important voice in favor of another possible soft landing. . . “I don’t know how many people expected that. “I know you don’t.”
The series of forecast errors began in early 2021.
At the time, a handful of prominent economists, including Lawrence H. Summers, a former Harvard Treasury secretary, began warning that America could experience a surge in inflation as the newly elected Biden administration adopted a sweeping stimulus package — including one-time checks and state and local aid — on top of the previous Trump administration’s coronavirus relief. They feared that the silver would be in such high demand that it would drive up prices.
Many government officials and economists highly doubted that inflation would rise, but rising prices did. This was partly due to demand, and partly due to bad luck and pandemic disruptions.
Pandemic-related stimulus and lifestyle changes helped stockpile goods at a time when the supply chains set up to deliver these products were under strain. Shipping routes were unprepared to handle the deluge of demand for sofas and gym equipment. At the same time, manufacturers have faced gradual shutdowns due to virus outbreaks.
Russia’s invasion of Ukraine in 2022 has further fueled rising prices by disrupting global supplies of food and fuel.
That summer, the U.S. consumer price index had peaked at an annual increase of 9.1 percent, and the Fed had begun to respond in a way that made economists think a recession was imminent.
In March 2022, Fed policymakers began what quickly became a rapid series of rate hikes. The aim was to make it significantly more expensive to buy a house or a car or to expand a business, which would slow the economy, weigh on consumer demand and force businesses to stop operating. increase prices.
Such interest rate adjustments, intended to curb inflation, typically triggered recessions, so forecasters began predicting a slowdown.
“History has shown that these two things combined usually result in a recession,” said Beth Ann Bovino, the bank’s chief economist, referring to the combination of high inflation and rate hikes.
But the economy — while tough for some families, between high prices and expensive mortgages — never fell off that cliff. Hiring is gradually slowing down. Consumer spending has slowed, but in fits and starts and never abruptly. Even the real estate market, sensitive to interest rates, has stabilized without collapsing.
Strong government support helps explain some of the resilience. Households were flush with savings accumulated during the pandemic, and state and local officials were only slowly spending their own government pandemic money.
At the same time, a strong labor market has helped push up wages, allowing many households to cope with rising prices without having to make big cuts. Years of extremely low interest rates have also given households and businesses the ability to refinance their debts, making them less susceptible to the Fed’s campaign.
And part of this continued strength is because with inflation slowing, Fed officials may backtrack from crushing the economy. They suspended rate hikes after July 2023, leaving them in a range of 5.25 to 5.5 percent.
This raises a question: why has inflation slowed even though the Fed has failed to bring down growth?
Many economists previously thought a deeper slowdown would likely be needed to completely stem rapid inflation. Mr. Summers, for example, predicted that It would take years of unemployment above 5 percent to bring price rises under control again.
“I believed that the soft landings” were “the triumph of hope over experience,” Mr. Summers said. “This seems like a case where hope triumphed over experience.”
He highlighted several factors behind the surprise: among them, supply problems eased more than expected.
Much of disinflation is due to the reversal of previous bad luck. Gas prices fell in 2023, and these lower prices have spilled over to other sectors. Healing supply chains has allowed good prices to stop rising so quickly and, in some cases, collapse.
And an economic cooling has taken place. Although unemployment has remained relatively stable, the labor market has rebalanced in other ways: there has been about two job offers for every available worker in 2022. That figure is down to 1.4 now, and wage growth has slowed as employers compete less fiercely to hire.
But this labor market adjustment has been smoother than expected. Prominent economists had doubted it would be possible to calm the situation by removing job offers without also causing an increase in unemployment.
“I would have thought it was an iron law that disinflation is painful,” said Laurence M. Ball, a Johns Hopkins economist and author of a book on disinflation. influential article of 2022 which argued that reducing inflation would likely require increasing unemployment. “The big lesson, which we never seem to fully understand, is that it is very difficult to predict things and we should not be overconfident, especially when there is a very strange historical event like Covid. “
It remains to be seen what this means for the months to come. Could economists still be caught on the wrong foot? They expect moderate inflation, continued growth and several rate cuts from the Fed this year.
“We landed softly; we just have to get to the door,” Mr. Furman said.
Fed officials could provide insight into their own thinking at their meeting next week, which ends Wednesday. Investors expect policymakers to keep interest rates steady, but they will be watching a news conference with Jerome H. Powell, Chairman of the Fed, for clues about the future.