O soft landing, where art thou?
What a difference a year makes. At the beginning of the year, pessimism about the direction of the economy was almost everywhere. It was hard to find anyone who didn’t think a recession would happen. Virtually every metric was expected to move in the wrong way. Looking at where things have ended up, it’s amazing how wrong all of that was.
Unemployment is less than 4% and has been that way for two years. The last time it was that low for that long was in the 1960s. That comes despite interest rates being raised at the fastest pace ever.
The first quarter of the year saw Silicon Valley Bank abruptly collapse. There was widespread fear then that a banking panic was going to happen and weigh down the rest of the economy. Luckily, the Fed, FDIC and Treasury stepped in and the damage was contained.
After that episode, there was a concern that lending would become tighter because of recession fears and banks being more cautious. Not only did that not happen, but financial conditions have actually loosened since that time. In other words, it became easier to borrow right after there was a major bank failure and fears of a panic. That’s not how it’s supposed to work when that happens.
The Silicon Valley Bank saga was one of many that didn’t unfold the way they were expected to. Economists in the government and private sector widely agreed that inflation would come down this year, but thought unemployment would go up, maybe even as high as 6%. They were half right.
Inflation has continued to go down. In fact, the Personal Consumption Expenditures index, which measures inflation minus food and gas prices, has now been running at 1.9% for the last six months. That metric is important because it’s the Fed’s preferred measure of inflation and it is now slightly below their 2% target.
They were dead wrong about unemployment. Not only has it not gone up, but jobs keep getting added each month. Hiring has slowed over the last year as has wage growth. Believe it or not, those are both good things. The huge pace of hiring that was seen when the economy began reopening in 2021 and continued into 2022 was never going to last. Demand for workers is still strong and that’s good. It’s just at a more modest level and not so high that it leads to higher prices.
In contrast to the widespread pessimism about where the economy was headed a year ago, today it’s nearly the opposite. Economists in the government and private sector are now predicting a soft landing will happen. What was thought to be impossible a year ago is now seen as the most likely outcome.
To be sure, that doesn’t mean a recession won’t happen. Even in the best of times, the odds of a recession happening are never zero. Even if everything continues to go well, there is always a chance an external event could mess it up, i.e., a major oil price spike. In any event, given that the same crowd predicting good times ahead thought the opposite would happen a short while ago, it’s best to take their predictions with a grain of salt.
That said, absent some external event intervening, as of now, it looks like we are on track to achieve a soft landing. No, I’m not going to predict that’s what will happen. As is my MO, I don’t prognosticate about large-scale macro events of any sort. Still, it’s worth looking at why predictions of a recession have so far proven to be wildly off the mark.
Before going any further, let me put my cards on the table. I first started writing about the economy and inflation in the summer of 2021 and have written about it many times since then. I have never once made a prediction about inflation, interest rates, unemployment or any other metric. I wrote many times about predictions of a recession and was consistent in articulating what I thought would happen: I had no idea.
I frequently pushed back against those arguing that there would be a recession not because I was convinced they were wrong, but because they seemed so certain they were right. In their defense, they had a lot of evidence on their side. The last time inflation in the US was high, it was brought down only by the Fed inducing what was then the worst economy since the 1930s. As long as the Fed has dealt with inflation, there had never been a soft landing. The experience of other countries was similar as far as I could tell.
It was also arguably the case that the Fed was late to respond to the surge in inflation. The argument from the Fed in 2021 was that inflation was transitory and would go down on its own so they could wait to raise interest rates. When inflation persisted, the Fed raised interest rates very quickly. It’s not unreasonable to believe an abrupt surge in borrowing costs would raise unemployment.
Monetary policy is said to operate with a long and variable lag. That is to say it can take a long time for the raising of interest rates to be fully felt in the broader economy. The reason that matters is because it means there can be a big gap between when interest rates first rise and when a recession starts.
The long and variable lag idea is, I think, the most compelling piece of evidence that we aren’t entirely out of the woods yet. Maybe it’s the case that the rise in interest rates since March of last year is going to break things, but it has just taken longer than most thought. I have no idea whether that’s right, but if we do have a recession not caused by some external event that seems like it would be the most likely culprit.
Evidence in favor of a recession happening notwithstanding, what those arguing it seemed to be missing was the uniqueness of this economy. Those making that case were often relying on models that didn’t take into account the supply side of the equation. It was as if demand was the only factor at play. Demand is certainly important and likely played a big role in the inflation surge, but supply played a role, too, and arguably much bigger.
I frequently emphasize how different this economy is, but that probably seems a bit abstract so I’ll try to make it a little more concrete here. Most economic downturns are caused by a fall in demand. For example, when the financial crisis hit in 2008, banks pulled back on lending. Consumers and businesses couldn’t get as much credit, which meant their spending decreased. That translated into lower demand for workers, which meant higher unemployment for years. The Great Depression was like that, too, just much worse. While I’m no authority on the history of economic downturns, I can’t think of any off the top of my head that were driven by supply issues, at least not in the US.
That is what makes the pandemic economy so unique. Demand from consumers and businesses was kept afloat by Congress and the Fed. The problem was supply. Businesses of all sorts spent a good part of 2020, 2021 and even 2022 entirely or partially closed. Because of that, there was a big shortage of many goods and services and there were millions of workers who were out of the workforce. Because of generous aid given to individuals and businesses, workers’ incomes did not collapse and business failures were kept to a minimum.
We all remember the supply chain issues that plagued most every kind of good in 2021. We all remember the large numbers of “help wanted” signs posted on businesses everywhere during that time, too. Both of those are largely over now. That is what has made this economy so different.
Manufacturers overcame supply chain bottlenecks and have now been able to ramp up production of all kinds of goods to accommodate demand. Millions of workers who left the workforce during the pandemic have now returned. Overall demand has been reduced, i.e., interest rates are higher and stimulus spending is over, but because the supply factors have healed unemployment has remained low.
There was no precedent for messed up global supply chains or millions of workers leaving the workforce in such a short time. If both of those things remained true, those arguing a recession would happen likely would have been right. That would have meant millions of workers were not coming back and supply chains were permanently hindered. In that case, demand would have been the big problem and would have to be brought down significantly. Supply would not have been able to come to the rescue.
Fortunately, that was not the case. Models predicting a recession that looked at past economies didn’t take those things into account because they couldn’t. Past economies didn’t have the issues that the pandemic economy has. Simply looking at historical events in a limited time period, i.e., 1945-2020, is going to be of limited use when that period never experienced anything like what we’ve been through since 2020.
It’s true that bringing down inflation from such a high level without causing a recession was unprecedented. I don’t think there is anything wrong with pointing that out. What I do have a problem with is not understanding the distinction between unprecedented and impossible. Just because something has never happened before doesn’t mean it can never happen. Things are unprecedented until they aren’t. Someone claiming that the only possibilities are things that have happened before is admitting they have no imagination and are wedded to their rigid ways.
Not only did those arguing a recession would happen make the error of not taking into account the distinctive features of the pandemic economy, they also relied on a small sample size. In the case of the US, the number of inflation episodes since 1945 is very small. The number of times the US has experienced high inflation and brought it down by raising interest rates is literally just one.
Even if you expand the number of countries looked at, the sample size is still fairly small, doesn’t deal with anything like the pandemic economy and many of the countries looked at are just not comparable to the US. It’s not rare for developing countries to have obscenely high levels of inflation, for example. However they have dealt with it (or are dealing with it), their situations and economies are nothing like that of the US.
On a philosophical and moral level, a problem I had with those arguing that a recession was the only path forward was I saw it as defeatist. According to its proponents, the only way to get inflation under control was to throw millions of people out of work. How long that would last was unknown, but it could have been for many years. Absent a large increase in unemployment, the argument went, inflation would take on a life of its own and become entrenched. Eventually, a big recession would be necessary to bring it down. Sooner or later, millions of people were going to have to lose their jobs.
Not only did I have philosophical and moral issues with that idea, but it made me angry on a visceral level. That was because those arguing for it were never in any danger of losing their jobs. It’s easy to talk about how unemployment will need to go up when you don’t have to bear any of the burden. I'm sure they would have been singing a different tune had they been facing the prospect of years of unemployment and all the hardships that come with it.
What to predict when you’re predicting
Like I said, I didn’t predict that there would be a soft landing. I was not prescient on anything. Nothing I have written on the economy should be considered a profile in courage. That would require me to stick my neck out, which is not how I operate. If I was ever going to make a bold prediction, it would be on something I know very well and the economy is not one of those things.
In looking at why predictions of a recession have been wrong, my intent is not to laugh at or to call anyone stupid. Accurately predicting macroeconomic events is hard. Predicting such events consistently is as close to impossible as anything can be. As I have mentioned before, the last three years alone have stumped everyone. There is not one economic prognosticator alive who hasn’t been wrong about something big.
I certainly don’t think making predictions is per se bad. Businesses do it all the time because they have to. For example, car makers will plan on making X amount of cars based on what they think demand will be. That, however, is different from macroeconomic forecasting, which may be a fun past time, but has little value beyond that.
If someone wishes to try macroeconomic forecasting, they’re free to do so, whatever makes them happy. All I ask is that they do it with humility and with the acknowledgment that they likely will be wrong in some significant way(s) and are really just guessing. If someone is willing to do it that way, they have my respect.
What I can’t stand is those who think by using math and statistics they’ve solved an unsolvable puzzle. The amount of confidence people have had in predicting where the economy is headed just because their models said so has been insane. A rule of thumb I have is the more confident someone is that they can predict the future, the less confident you should be in them. I would say it’s looking pretty good right about now.
The vibes they are a changin’?
I wrote recently on the big gap between the objective state of the economy and how people feel about it. There was until recently a big debate among pundits and commentators about how much of the negative views of the economy was justified based on the data and how much of it was non-economic in nature. That phenomenon has been a hot topic since it was first observed during the summer of last year. Even though unemployment was low and growth was strong, the economic mood was grim. Belief that a recession was looming was almost everywhere. Inflation was still high and outpacing wage gains.
For more than a year, inflation has continued declining while jobs have continued to be added. Growth and consumer spending have also remained strong. Despite that, economic sentiment was very low as recently as last month. However, things may be starting to change.
Beginning in July, wage gains finally started to outpace inflation. It was going to be a while before sentiment caught up with that. Nearly two years of real wages declining won’t be erased overnight. With respect to overall inflation, it’s now down two-thirds from its peak. More specifically, gas prices, which consumers are highly attuned to, are at roughly $3 a gallon, down from nearly $5 a gallon in June of last year.
Assuming those trends continue, people are going to feel better going forward. The raising of interest rates has made home buying much more expensive, but that looks like it has peaked. Thirty-year mortgage rates, for example, have already started declining even before the Fed starts to lower interest rates. They are still much higher than they were a short while ago, but are headed in the right direction. If interest rates are lowered next year, that will continue and home buying will increase, which will make people happier.
Like so many other aspects of the economy, the pandemic has altered how people view it. In 2020, unemployment quickly surged before beginning a big and sustained fall. The large amount of aid provided ensured that people didn’t lose everything. Even though people had plenty of money, they were limited in what they could do with it and life in 2020 was anything but normal.
Even when the economy reopened, there were setbacks along the way. Vaccines became widely available in 2021, but when Delta and Omicron hit many people freaked out. Life didn’t fully return to normal until 2022.
It’s only now, at the end of 2023, when things are starting to line up just right. Consumer sentiment is finally moving upwards and, by at least one group’s calculations, is as high as it has been in two years. It still is low and has a ways to go before we can start celebrating, but it’s on the right track.
Right now almost all metrics are headed in the right direction. That includes unemployment, inflation, interest rates, wages and productivity. If that continues, people will feel better and the gap between how the economy is and how people feel about it will shrink.
We’re doing alright, folks. We’ve been through a lot for almost four years now, but things are going to get easier. You don’t have to take my word for, just ask The Five Stairsteps.