OPINION:
Recent economic news has been good at raising optimism about a soft landing and speculation about where interest rates will ultimately settle.
Growth accelerated in the second quarter to 2.4%, and consumer price inflation was 3.2% in July.
Now, can Federal Reserve Chairman Powell artfully maneuver interest rates to take inflation to 2% without derailing the economy?
Consumers will face headwinds in the future because the excess savings built up with unspent federal relief payments during the COVID-19 shutdowns are running out. But after a long decline, real wages are rising again, and both the Conference Board and University of Michigan measures of consumer confidence are improving.
The Chips and Science Act, Inflation Reduction Act and breakthroughs in artificial intelligence are instigating booms in factory construction for semiconductors, electric vehicles and green industries and in software development.
To finance federal incentives and more health care spending, the federal deficit for the fiscal year ending in September will likely hit $1.85 trillion or about 6.9% of GDP.
In 2019, when the economy was last at full employment and free of the aftershock of COVID-19, the deficit was $986 billion and 4.6% of GDP.
A 2.3 percentage point jump in stimulus should support positive real GDP growth no matter what the rate of inflation. If we get a pause in growth from consumers pulling back as savings run out, the hiatus should be brief and shallow.
The consensus of economic forecasters compiled by Bloomberg indicates no recession but rather slower growth in this year’s 4th quarter and 1st quarter of 2024. Forecasters anticipate the Fed will start lowering interest rates in March.
That would indicate either the economics profession believes the Fed’s target of 2% inflation is easily within reach or the central bank will abandon that target in favor of something higher—perhaps 3%.
Getting inflation from 3.2% to 2% will prove challenging—at least without the Fed tightening monetary policy enough to instigate a mild recession.
Although the structural constraints on supply that COVID-19 imposed—in particular, the shutdown of the Chinese economy—have passed, other unforeseen problems have emerged.
Climate change is imposing record storms in some places and droughts in others, constraining agricultural production and impeding shipping along inland waterways. The war in Ukraine is limiting its grain exports, and Kyiv’s new cruise missile capacity now permits attacks on Russian Black Sea exports.
All of this will put upward pressure on food prices in the months ahead.
Geopolitical tensions are causing a dramatic shift in the sourcing of U.S. manufacturers. Through the first six months of this year, imports from China were down 25% from last year—that’s even more impressive considering that last year much of the Middle Kingdom’s factory sector was impeded by COVID-19 lockdowns.
In the near term, the resulting Chinese factory deflation and a weakening yuan exchange rate reduce prices for products from China. But as sources of supply rearrange in Asia and some production is reshored or moved to Mexico, higher labor costs will put upward pressure on prices.
In a nutshell, the era of cheap hands in Asia to assemble everything from chairs to cell phones is coming to an end and an important source of low inflation during the pre-COVID era recedes with it.
Those optimistic about a soft landing—accomplishing sustainable inflation at 2% while continuing a reasonable pace of growth without a recession—give short shrift to the above mentioned supply-side considerations and focus on the accomplishment of former Federal Reserve Chairman Alan Greenspan in 1994.
In February of that year, he started raising interest rates and managed to pull down inflation minus the volatile food and energy sectors from 2.9% to 2.1% without a recession. But a 0.8% reduction in the pace of inflation is hardly on the scale of the task Mr. Powell has faced.
And Mr. Greenspan did not have a war raging in Europe disrupting global petroleum and natural gas supplies, rising global temperatures running hazard through food supplies and electrical grids, and federal deficits so large that Finch has downgraded the creditworthiness of the U.S. government.
Simply the history of soft landings and its relevance to our circumstances are highly questionable.
Similarly, many economists advocate moving the goalposts by raising the target inflation rate to 3% or higher. But inflation becomes more volatile at higher rates, and any target chosen above 2% would be more difficult to maintain.
Beyond the early quarters of next year, the U.S. economy is likely headed for a period of growth in the 2% range and structural inflation somewhat above that level.
Applying the rule of thumb that the neutral rate of interest that will neither substantially increase unemployment nor accelerate inflation is equal to the sum of trend growth and inflation, we can expect Fed policy supporting a 10-year Treasury rate of 5% to continue.
• Peter Morici is an economist and emeritus business professor at the University of Maryland and a national columnist.
Please read our comment policy before commenting.