As we approach the end of 2022, investors are hoping that inflation will fall in 2023 and lead the Federal Reserve to pause and perhaps reverse some of its interest-rate hikes. The looser financial conditions would then allow for accelerating economic growth and a better year for financial markets.
Well, not so fast. The parts of the economy that have been slowing down in recent quarters are the same ones that are poised to rebound sharply in such a scenario. That creates a challenge for the Fed that's likely to persist even after supply-chain problems and pandemic-related inflation abate.
As last week's third quarter gross domestic product showed, there have been four categories of economic activity that have been significant drags on growth this year. Two of those are the result of consumer behaviors normalizing after the pandemic, and two were caused at least in part by the Fed's rate increases.
Earlier this year, consumers shifted their spending habits from goods to services, and the slowdown in "buying stuff" has had a cooling effect on economic growth for the past two quarters. Because consumers have been buying less stuff, companies have been drawing down some of the inventories they built up, meaning inventories have been a drag on growth as well. This may persist for the rest of the year but it's ultimately temporary. At some point next year consumer behavior and retail inventories will normalize and no longer hinder growth.
The Fed-related drags have been in residential housing investment after the sharp rise in mortgage rates, and in the construction of nonresidential structures — such as office buildings — as higher interest rates, recession fears and questions about post-pandemic norms have restrained new projects.
These four categories were negligible contributors to GDP growth in the first quarter of 2022, detracted 3.8% from growth in the second quarter, and detracted 2.8% from growth in the third quarter. And with all those trends continuing, we should expect them to be drags on growth again in the fourth quarter.
But imagine where we might be in the middle of 2023: Continued healing of supply chains and a pickup in auto production puts sustained downward pressure on goods prices. Market rent growth continues to slow as more of the excess household formation from 2020 unwinds and new apartment supply comes online. And the labor market stabilizes enough that the Fed feels confident it has succeeded in reining in inflation. So the Fed stops the rate increases and the improved inflation outlook prompts investors to start pricing in future rate cuts.
That's where a whole a new set of problems come in, albeit better ones than we're currently confronting. That's because the four categories of economic activity that slowed down enough to help the Fed win its inflation battle would likely turn around and start boosting growth again. And that abrupt swing from contraction to expansion would quickly push the economy beyond its limits, bringing back supply-chain problems, labor shortages and inflation.
Looking at it numerically, real GDP growth averaged 1% between the second and third quarters of 2022. But shifting the headwinds to tailwinds for goods, inventories, residential investment and nonresidential structures next year could push the pace of real GDP growth to 5% or higher. And at a time when the unemployment rate remains historically low, and the Fed is aiming for real GDP growth to be sustained long term at a 1.8% pace, the Fed would likely consider the situation unsustainable and want to rein it in again.
Think of the economy as an understaffed club that the fire marshal decided was operating at an unsafe capacity, so membership has been steadily decreased over several months. Meanwhile a crowd has gathered outside waiting to be allowed back in, and the building is quickly overwhelmed again when the doors reopen.
There are more dollars waiting to be invested and spent than the US economy is going to be able to handle after this bout of inflation cools down. Financial conditions are going to have to remain tight enough to balance supply with the surge in demand we're likely to get. So while there's reason to hope inflation will fall next year, don't expect that to mean the Fed will be able to back off its supply-and-demand balancing act any time soon.
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