Where will the economy go?
The economic outlook for 2022 and 2023 in the United States is good, though inflation will remain high and storm clouds grow in later years.
The war in Ukraine raged with uncertain outcomes while this forecast was prepared. The war will play only a small role in the American economy—unless it really turns into World War III, which doesn’t seem likely.
A reporter recently asked, “What’s the most important economic statistic for business leaders to follow in 2022?” It is not an economic statistic; it’s Covid. The best working assumption for an economic forecast is that Covid has less impact, thanks to vaccinations and past infections. Assume no more lockdowns and people will dine out, travel and go to concerts. But keep your fingers crossed, as new variants are quite possible.
Economic growth will be pushed up by past stimulus, both fiscal stimulus and monetary stimulus. No additional major stimulus will come this year, but stimulus always works with time lags. So this year’s economy is mostly driven by past stimulus.
Supply constraints limit our growth no matter how much stimulus is pushed into the economy. Look for inflation-adjusted GDP to increase by 4% this year, then a little faster 2023.
The current supply constraints will ease gradually but not go away. More workers will return to the labor force as schools re-open reliably and as stimulus payments and unemployment insurance benefits are farther in the past. Most of our supply chain problems have been labor problems, and the shipping and production issues will be slowly resolved. Optimistic is justified, but gradually, not immediately.
Inflation will remain high this year and next as our past stimulus keeps pushing prices up. Although supply problems will ease, that’s only a small portion of our inflation. Mostly, we have had way too much stimulus relative to our productive capacity. The Consumer Price Index will likely rise by 6.5% this year and 6% in 2023.
What will the Federal Reserve do? They are certainly going to tighten. Right now they only partially agree that we’ve had too much stimulus already. They continue to believe that supply chains are the major issue. But as the year goes by, they are likely to change to a belief that stimulus has been excessive.
Short-term interest rates will move up from about zero now to just under 2% by the end of 2022, with another two and a half percentage points of increase over the course of 2023. This is a much larger gain than most economists are forecasting, and much higher than the Fed’s policy-making officials expect they will have to do. But continuing high inflation will lead to changes opinions.
The Fed will also shift from keeping long-term interest rates down through their purchases of treasury bonds and mortgage-backed securities. They will start shrinking their assets, which will have a contractionary effect on economic growth. At the same time, most foreign long-term interest rates will rise slowly, as the global demand for credit increases faster than the global supply of savings. So 10-year treasury bonds will yield about 4% by the end of 2023, with home mortgage rates up to 5.5%.
That sounds scary to some, but leaves interest rates well below historical averages.
What happens beyond 2023? This is the scary part of the forecast. The Federal Reserve has a huge challenge in that their policies work with time lags. The time lag from Fed action to employment is about one year, and the time lag from action to inflation is about two years. This is a simplification, of course, with some effect coming in a quarter or two, then rising to a peak and then diminishing. But think of a short time lag to employment effects and a longer time lag to inflation.
When the Fed starts tightening, at first . . . nothing happens. There will probably be articles in newspapers saying that monetary policy no longer works—there always are. But then employment growth will slow down—but not inflation. We’ll call that stagflation. What will the Fed do then, when they have tapped the brakes but inflation is still going too fast? Will they press down harder on the brakes, or will they worry about job losses and hit the gas?
In the 1970s the Fed made repeated mistakes. They learned some lessons, but their goals are not just two percent inflation, but also good job opportunities. They like having a job market where jobs were available even to high school dropouts with prison records.
If the Fed persists with fighting inflation, we’ll be at risk of a mild recession, but inflation will be tamed. But if they fail to fight inflation now, then they will be postponing the pain, and they will have to tighten even harder when they eventually deal with inflation, likely resulting in a more severe recession.
Which course they will choose is difficult to say, but the economy is already set up for a more cyclical path. It’s like driving on an icy road. Keep the car going straight, and everything is good. But once you start swerving, it’s very hard to get back under control.
One of the things economists know from history is that economies with low inflation tend to have stable growth. But high inflation economies tend to be very cyclical.
Economic changes in high inflation and low inflation.
For example, economic growth in the decade before the pandemic varied only a little, with no recession over an entire whole decade. What would this look like in a high-inflation economy? Well, we ran that experiment in the 1970s and early 1980s, as the chart shows.
Business leaders should expect that in 2024 and beyond, the economy will be more cyclical than they have experienced over most of their careers. The booms will be boomier, and the busts will be bustier.
The near-term outlook is solid because of past stimulus, but the later years bring great risk of recessions.
