A Long Way From Normal
It’s been an odd few days.
On Wednesday the Fed delivered another large rate hike (three quarters of a percentage point) and indicated that monetary tightening will continue. Yet equity markets rallied and bond yields fell.
The decline in bond yields could signal that investors expect monetary tightening to push the US economy into recession, forcing the Fed to then reverse course and cut interest rates.
Why the prospect of a recession should boost stock prices seems more difficult to explain, but the stock market works in mysterious ways – at least to an economist’s eyes.
So how is the US economy doing?
Thursday’s GDP release showed the US economy contracted by 0.9% (annualized) in the second quarter of the year. This follows a 1.6% contraction in Q1, and two consecutive quarters of negative growth are the unofficial rule of thumb for a recession.
The official designation of recession requires a more complex assessment of a wide range of economic indicators – this is what economists at the National Bureau of Economic Research do, but their verdict will come much later. And anyway, the issue is not the exact definition of recession.
The issue is that major economic indicators point in very different directions. As Fed Chairman Powell said on Wednesday, it’s hard to believe we are in a recession when firms keep adding jobs and the unemployment rate holds steady at the lowest level in half a century. The economy added 2.7 million jobs during the first half of the year. Consumer spending grew 1% in Q2. Less than in Q1, but still healthy growth.
Inflation is inflicting real pain, with higher prices eroding purchasing power. Yet, as
the Wall Street Journal noted, “People continued to travel and shop as more people gained jobs”. With a rising cost of living and strong excess demand for workers you would expect a lot more people to come back into the labor force – but that’s not happening yet.
Data, anecdotal evidence and opinion polls are all over the place: people say they are pessimistic about the economic outlook, but also plan to spend and go on holiday; we read of more companies laying off workers, but many still struggle to fill vacancies.
These mixed data give little confidence that inflation will come down sharply and quickly. Commodity prices have cooled off, and this will provide some relief in the coming months. But price increases are now broad-based, supported by resilient demand and a hot job market. Friday’s Personal Consumption Expenditure release showed that PCE inflation (the Fed’s preferred measure) held steady at 6.3% in May, with core PCE down only slightly to 4.7%. The Q2 Employment Cost Index, flagged by Powell as a key gauge of wage pressures, came in slightly higher than expected (though marginally lower than Q1).
Yet financial markets seem to believe that policy interest rates will peak around 3.3% - below what the Fed has indicated – and that by early next year the central bank will start cutting rates again.
In sum, it’s unusually hard to understand what’s happening in the economy, and financial markets reactions are equally puzzling.
I suspect the main reason is that after several years of massive and pervasive government interventions, the economy still struggles to regain a degree of normalcy.
Over the past several years policymakers launched gigantic and pervasive interventions in the economy: massive asset purchases, lockdowns, subsidies to households and businesses to cushion the impact of lockdowns, restrictions on global travel and global trade. I will not argue here to what extent these interventions were justified. I do think they have disrupted industries and distorted the incentives of workers, consumers, businesses and investors. And they have sowed fear and expectation that similar interventions will recur.
Labor force participation treads water a full percentage point below pre-pandemic levels. Industries struggle to repair supply chains, to bring production fully back on line and to recalibrate inventories levels – balancing the rebound in demand against the fears of recession. And financial investors seem convinced that policymakers will always guarantee the “new normal” of ample liquidity and near-zero real interest rates.
It will take a lot longer for the market economy to reabsorb and iron out the disruptions suffered in the last few years. It would be helpful for policymakers to gradually step back, restoring policies to a more normal, “neutral” setting. This will be hard, given the multiple calls for new policy interventions: to alleviate the impact of high energy prices, to limit sovereign spreads in the Eurozone, to support specific industries, to name a few. The risk is that renewed rounds of policy interventions will make it harder for the economy to heal and for policymakers themselves to gauge the true underlying economic trends – harming long-term growth in the process.