Economists tend to make good fly fishermen. They pay attention to detail. They are meticulous in their preparation. They perfect technique.
But what makes economists particularly well-suited as fly fishermen is their ability to cast about repeatedly without success, yet without such failure diminishing their passion for the task.
The past few years have been particularly challenging ones for economists. Wrong-footed by 2022 inflation, most predicted it would be transitory. Then, when the yield curve inverted last year, the consensus roared recession. And when China dropped its zero-Covid policy at the end of last year, most economists predicted a booming 2023 economy.
Each of those forecasts, however, landed like the ugly splash of a badly cast dry fly, serving only to scatter the intended audience, rather than entice them to rise to the occasion. Inflation remained higher for longer, a US recession is nowhere in sight, and China’s vaunted 2023 recovery is spluttering before the year is even half over.
Yet fly fishing, like economic forecasting, is nothing if not an exercise in patience. Wait long enough, and fortunes may change.
Cue US inflation, which is proving to be transitory. It just took longer than expected. After all, it has not taken a recession, much less even much of a slowdown in US jobs growth, to bring down headline consumer price inflation from its peak of 9.1% in June 2022 to 4.3% less than a year later. Core measures look stickier, but mostly because of misleading lags regarding shelter costs, as well as temporary distortions in used car prices. Remove those anomalies and the forecasts of economists look a lot better.
More importantly, inflation is receding for fundamental reasons. Adverse supply shocks stemming from the pandemic and Russia’s invasion of Ukraine are not being repeated. Disruptions to global production and distribution are being alleviated. Temporary spending booms unleashed by massive fiscal stimulus and pent-up consumer demand have receded. And, perhaps most critically, as a plethora of indicators suggest, last year’s price and wage gains are not becoming embedded into agents’ expectations, which greatly reduces the risk of self-reinforcing price and wage spirals.
So, when it comes to forecasting inflation, it seems economists were not so much casting badly, as they were casting a bit too soon.
Could the same be said about the global business cycle? Are economists wrongly predicting the outcomes, or are they just too early?
First, give credit where it is due. By the narrowest of margins—namely consecutive -0.1% declines in real Eurozone GDP for Q4 2022 and Q1 2023—the consensus of last year’s forecasts that war in Ukraine coupled with efforts to tackle high inflation would lead to recession in Europe have materialized. The profession landed that fish.
The same, however, cannot be said for US recession forecasts. Dire predictions began to emerge 14 months ago, when the US yield curve (historically a reliable leading indicator) first inverted. Not only has the US economy refused to buckle, but the number of monthly jobs created remains, on average, more than twice the rate of the growth of the labor force. That’s unheard of during a period of aggressive rate hikes culminating in a deeply inverted yield curve.
What has the profession missed with its US recession forecast?
Let’s begin with what it got right. Higher interest rates have contributed to outright declines in the US residential and commercial real estate sectors, as well as in overall business investment spending. Those parts of the economy have borne the burden of higher interest rates and, in the case of commercial real estate, have witnessed a dramatic decline in occupancy rates as workers resist returning to the office full time.
Also, a stronger US dollar, coupled with economic weakness abroad, has pushed down the real value of US exports.
So, economists have not been entirely wrong—tighter monetary policy via higher interest rates and a strengthening currency has sapped vigor from the US economy.
But the consensus of economists has clearly missed profound changes in the labor market and household savings, differences that have proven decisive in this cycle. Specifically, significant shortages of skilled workers—owing to seemingly permanent post-Covid decline in the labor force participation rate—alongside more than a trillion dollars in accumulated household savings have kept consumers more buoyant than in past cycles. Confident in their job prospects and reassured by their cash holdings they have kept on spending. And, as the Federal Reserve Bank of San Francisco noted last month, those excess savings could keep consumption ticking over through the end of 2023.
Moreover, the decline in headline consumer price inflation, coupled with steady jobs growth and nominal wage gains, is underpinning an acceleration of real household disposable income growth, which rose at a 3.4% rate in the first quarter of 2023. Until inflation-adjusted household income growth slows, it will be difficult to see much deceleration of final demand.
Lastly, although monetary conditions, as measured by real short-term interest rates, are progressively tightening, rising stock and more recently rising bond prices are providing some offsetting easing of financial conditions.
That is not to say that a US recession might not yet occur. Rather, the key message is an age-old warning, namely that naïve reliance on historic patterns—in this case the predictive power of the yield curve—is risky, particularly when the economy has undergone the kind of profound transformations it has in the past few years. Above all, the jarring pandemic changes in the US labor market and unprecedented fiscal largess of 2020-2022 have created forces that, for a time, have overwhelmed conventional statistical models of the US business cycle. In the analogy of fly-fishing, the stream still holds trout, but the water is so clouded from an unusual spring run-off, that the fishing is just not what it used to be.
Which brings us to a final comment. A recession is defined as a broad-based decline in output and employment lasting more than a few months. Arguably, what the US economy is and will experience is something different, namely a series of rolling, sectoral recessions. Those are already underway in property markets, capital spending, and exports. Manufacturing is on the edge of contraction.
But so long as real household income is supported by rising inflation-adjusted wages and jobs growth, the broader economy will continue to expand. And by the time consumer spending softens, today’s depressed sectors may have bottomed and could begin to cushion the effects of weaker consumption.
In short, a soft-landing remains possible, and the longer the labor market remains intact and inflation continues to decline, the more likely it becomes.
