Economists did not believe it was possible, but they’ve been wrong a lot lately, and in their defense it has only ever happened once (or maybe twice) before: We may be witnessing that rare achievement known as a soft landing. The US Federal Reserve’s latest forecast expects the inflation rate to slide back down to 2% without much job loss or economic slowdown.
But before we celebrate this bravura monetary performance, or decide unemployment and growth aren’t sensitive to inflation or interest rates after all, allow me to offer two observations, one looking backward and one forward. First, the last few years have been highly unusual. Second, this year will mark the end of the free-lunch economy.
The post-pandemic economy was marked by several unlikely factors. Shortages coming out of the pandemic sparked inflation, which was then exacerbated by unnecessarily expansionary monetary and fiscal policy. Just as the economy was poised to recover, in other words, policymakers gave it rocket fuel.
All that stimulus money increased household savings. Savings-rich households kept spending, and firms desperate for workers faced an exceptionally tight labor market. Meanwhile the Fed not only pursued nominal zero rates, it tried to bring down longer term rates and mortgages — and did so well after the pandemic had ended.
The result was that even as rates increased, the economy stayed somewhat resilient. During the long period of low interest rates that preceded the post-pandemic, many firms, investors and households locked in low rates. Thus they were relatively unaffected by rising rates.
Now, as we head into 2024, it’s increasingly clear that America has spent its post-pandemic dividend. Households in the bottom half of the income distribution don’t have so much extra savings, and some are even going into debt. Debt-dependent firms and investors are approaching their maturity wall and will have to refinance at a higher rate soon.
Even the unshakable labor market may be weaker than it appears. Coming out of the pandemic, job vacancies were historically high because firms needed workers and could not find them. They have since fallen, though they are still high from a historical standpoint — suggesting room for a soft landing.
But maybe those vacancy numbers are less meaningful than they used to be. Economists at the Minneapolis Fed speculate that technology has changed the relationship between vacancies and the employment market — making it easier to post, recruit and evaluate applicants — so they devised a better way to measure vacancies. When they did, they found that vacancies are back to their old level. They argue that higher rates could bring higher unemployment.
If the Fed does go forward with its planned rate cuts for next year, maybe the US economy can avoid the costs normally associated with inflation reduction. But if the inflation rate does not continue to decline — or worse, starts rising again — the Fed will face actual trade-offs. Bringing inflation down to 2% will mean inflicting damage to the economy, in 2024 and beyond.
That’s one conclusion from research by Jean Boivin, head of the BlackRock Investment Institute (and my macro professor in grad school) and Alex Brazier. For the last few decades, the Fed had only two speeds: expansionary or neutral. It has not directly caused a recession in decades.
Those days are coming to an end — because recent economic shocks have been mostly demand-driven. The only supply shock was a 30-year deflationary one, also known as the China shock. Prices stayed low and the Fed had lots of leeway to juice the economy without having to face the choice between inflation and growth. But in a world with an aging population and less scope for increased trade, the Fed’s long free lunch is over too. In fact, the last few years might have been its last hurrah.
There is a chance that, like a lot of my fellow economists, I am wrong. Perhaps the Fed will be able to reduce rates without much damage to the economy or the labor market; immaculate disinflation, so tantalizingly close, may actually happen. Whatever happens, however, the end of the pandemic dividend will make it harder for central bankers. For the first time in recent memory, the people who try to manage the US economy — not to mention the considerably larger group of us who participate in it — will have to navigate some difficult trade-offs.
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