The US economy expanded at a 2.4% annual pace in the second quarter, crushing consensus expectations and driving another stake into the 2023 recession narrative. But those inclined toward bearish views still have an angle to pursue over the medium term: perhaps the economy is too good and the Federal Reserve will have to raise rates beyond the current 22-year high, effectively stepping on the brakes even harder and dooming us to an ugly 2024.
That’s a scenario that Fed Chair Jerome Powell seems to be at least entertaining (but maybe without such a negative outcome). As Powell said at his press conference on Wednesday after the central bank raised its target rate 25 basis points, reducing inflation “is likely to require a period of below-trend growth and some softening of labor market conditions” — a mantra he has repeated for months.
But what’s “below-trend” growth, and why do we need it? Simply put, economists tend to believe that the economy has a speed limit above which it starts to overheat and can foster inflation. The intuition is that an economy can produce only so many goods and services in a given period, and prices tend to go up if demand outstrips supply. The Congressional Budget Office estimates potential GDP at around 1.8%, and the economy is clearly trending above that mark.
But the 2021-2022 bout of inflation was hardly a classic case of overheating, and there are a number of wrinkles to consider in the current context. The pandemic-era supply chain disruptions were unique in economic history, and many observers suspect that it may be possible to cool inflation to a degree without targeting demand. Consider the following decomposition from researchers at the Federal Reserve Bank of San Francisco, which suggests that supply factors were probably driving the bus for much of early 2022. Since then, the demand side may have slid tentatively into the driver’s seat, but note too (from the “ambiguous” contribution) that it’s impossible to understand the dynamics with precision.
At the press conference Wednesday, the Washington Posts’s Rachel Siegel asked Powell about the extent to which he thought rate increases had brought inflation lower, and his response was somewhat revealing (and consistent with the San Francisco Fed graphic above; emphasis mine):
Let me start by saying that the inflation surge that we saw in the pandemic resulted from a collision of elevated demand and constrained supply, both of which followed from the unprecedented features of the pandemic and the response from fiscal and monetary policy. And we’ve always expected that the disinflationary process would stem ... both from the normalization of those broad pandemic-related supply and demand conditions and from restrictive monetary policy, which would help return the balance between supply and demand by restraining demand. And we think that’s broadly ... what we’re seeing.
Toward the end of the response, he added:
I would say monetary policy is working about as we expect. And we think ... it’ll play an important role going forward, in particular in non-housing services where, really, we think that’s where the labor market will come in as a very, very important factor. So we think both of those — both of those sources of disinflation are playing an important role.
In other words, Powell thinks there’s a role for demand management in the disinflation process, and the fact that GDP remains as strong as it has may well support the case for further rate increases, which he left the door open to on Wednesday.
On balance, however, I don’t think this is likely to end as badly as bears might suggest. Under one scenario, Powell and the rest of the economic consensus may simply end up being wrong about demand-driven inflation. It may seem pie-in-the-sky, but it’s plausible that supply chains played an even larger role than we understand and that their normalization will resolve most of the problem. Bears may point to elevated wages as a source of sticky high inflation in the core services sector, but if you believe that wages simply followed inflation higher (i.e., people demanded higher wages to keep up with the rising cost of living), then it’s conceivable that they will now follow inflation lower without dinging the economy or labor market.
In another scenario, a strong economy is a problem for inflation — but just a minor one. Clearly, the Fed’s intention is to bring the economy down to below-trend growth, not torpedo it into a recession. To be a bear in this scenario, you must implicitly believe that Powell and his colleagues are doomed to overshoot, and that’s not where I stand.
Putting the pieces together, it’s reasonable to suspect that stronger growth may add to the case for another rate increase or two. Yields on two-year Treasury notes were up seven basis points at the time of writing, which suggests the market may partially agree. But for the most part, Thursday’s GDP report should be regarded as the encouraging development it is on the surface — not some “good news is bad news” setup for an ugly 2024.
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