John Kenneth Galbraith was a giant among economists. Giant describes the Canadian’s academic and also physical stature, as he was 6’8” tall. Galbraith was also a master wordsmith. Among his most memorable lines was: ‘The only function of economic forecasting is to make astrology look respectable’.
So, it is with the greatest trepidation that we venture forth with 2023 forecasts. Or, perhaps, non-forecasts.
In our next few contributions to Jackson Hole Economics, we consider the most salient debates in macroeconomics and capital markets, offering observations about how likely, plausible, or unlikely various outcomes will be. Our aim is to provide what technology guru and forecaster Paul Saffo calls the purpose of forecasting: ‘not to predict the future but to tell you what you need to know to take meaningful action in the present’.
We begin with the least likely outcomes for 2023. In our next two pieces (forthcoming in the next few days), we will review those that are plausible (and therefore merit close attention) and conclude with those that are likely.
So, let’s start with two of the most contentious points of debate, ones whose resolution could have important implications for financial markets in 2023.
No ‘immaculate disinflation’
Our first ‘forecast’ is no ‘immaculate disinflation’. In other words, the Fed is unlikely to restore price stability in 2023 without at least a mild recession.
According to the Federal Reserve’s dual mandate, the central bank aims to achieve price stability and full employment. With the current unemployment rate at five-decade lows of 3.5%, the latter objective is met. But price stability is not, despite some recent welcome declines in the rate of inflation. Can the Fed restore price stability, which it defines as a 2% ‘core’ rate of personal consumption expenditures (PCE) inflation, in 2023 without a significant increase in the unemployment rate?
We doubt it. True, inflation has begun to decline. But declines are thus far concentrated in goods prices, not services. The largest of the services categories—shelter—is typically a lagging indicator reflecting housing costs, including rents. Importantly, non-housing services prices are typically linked closely to wages. That’s critical, because wages are also a lagging variable and because wage inflation reflects how much slack exists in the labor market. The crucial point is that services inflation will only slow as wage inflation slows, which itself requires a rise in the unemployment rate.
In theory, there are three other ways the Fed could reach its inflation target without rising unemployment. But none of them appears likely to materialize this year.
The first would be if goods prices were to fall sufficiently to offset above-trend services inflation. But it is difficult to see how significant goods price deflation will occur given relatively lean inventories and still-tight global supply chains. Moreover, the re-opening of China’s economy is apt to increase demand for raw materials and energy, putting some upward pressure on various intermediate goods prices.
The second way inflation could fall to target without rising unemployment would be if higher labor costs were absorbed in corporate profit margins. To some extent, that will occur. As demand softens due to the Fed’s restrictive policy stance, many companies will find it difficult to pass along higher costs in the form of higher prices. But as profit margins come under pressure, firms will also respond by laying off workers. The first signs of hiring freezes and layoffs are already evident in the information technology and financial services industries. Others are likely to follow.
The final hope for ‘immaculate disinflation’ resides in an acceleration of labor productivity that would keep unit labor costs in check despite rising nominal wages. That would be a welcome ‘win-win’ for the economy, but it is unlikely. For one, labor productivity is typically cyclical, rising in upturns and falling in downturns. Accordingly, a 2023 productivity spurt would run contrary to history. Moreover, with a brief exception in the two years before the pandemic, productivity growth has been tepid over the past dozen years. Why should that now change?
In sum, US inflation will recede during 2023. But it is unlikely that ‘core’ inflation will fall below 3% without a significant slowing of labor costs, which would almost certainly require a rise in the unemployment rate. ‘Immaculate disinflation’ is unlikely to unfold in 2023.
No US default
Our second forecast is that the US Federal government is unlikely to default on its debts in 2023.
The advent, again, of divided government in Washington, DC raises the specter of a legislative impasse. Twice before – in the 1990s and from 2011-2014 – Democratic presidents faced hostile Republican majorities in the US House of Representatives. Disagreements over raising the US debt ceiling resulted in government shutdowns, a downgrade of US government debt and concerns that the government might not be able to meet its obligations to creditors. Markets were roiled by legislative brinksmanship and default concerns.
Today, confronted by a precarious majority hostage to radical elements in the Republican Party, freshly (and barely) elected House Speaker McCarthy is being pressured into the obstructionist tactics of his predecessors. Might the US default on its debt this year?
That is not an unreasonable question. Treasury Secretary Yellen has already outlined extraordinary measures to forestall that outcome. According to the Treasury’s forecasts, the government’s cash balances would dwindle by June, after which time a default could occur.
Several factors, however, suggest that worst case scenario will be avoided.
First, although the Biden Administration has stated that the debt ceiling must be lifted without preconditions, legislation almost always comes with strings attached. Concessions and compromise will be required to keep the government functioning. And, as President Biden has amply demonstrated via legislative success over the past two years, with his long experience in the US Senate he understands far better than Presidents Clinton or Obama how to get deals done on Capitol Hill.
Second, Republican obstructionism is apt to be politically costly. In 1996 and 2012, following government shutdowns and debt-ceiling dramas, Republicans lost House seats. With a wafer-thin 5 seat majority today, some Republicans—particularly those defending ‘purple’ seats—may balk at financial brinksmanship in 2023.
That is important, because it would only take the defection of a half dozen moderate Republicans to join a unanimous Democratic caucus to pass an increase in the government’s borrowing capacity. That is precisely how the debt ceiling impasse was broken in 2014, when then Republican Speaker Boehner allowed a ‘free vote’ on lifting the borrowing limit without restriction. Doing so allowed many in his own party to stick to their political positions and vote ‘no’, but it also permitted a group of 28 moderate Republicans to vote with a large Democratic bloc to ensure the bill’s passage.
Over the coming months, we should expect a great deal of political posturing, drama, and threats of brinksmanship. But we should never underestimate one truth of Washington—for most incumbents, power trumps ideology. For the vast majority in Congress, the desire to be re-elected is paramount. In the end, which may take us to the brink, pragmatism is likely to prevail.
Investors have much to preoccupy them this year. But the fantasy of ‘immaculate disinflation’ is not among them. Either core inflation will persist above the Fed’s target through year end, or the economy will buckle under higher interest rates pushing up the rate of unemployment. On a more positive note, the US government is unlikely to default on its national debt. Bravado and brinksmanship will ultimately yield to self-interest, and calamity will be avoided.
Finally, what do these outcomes imply for markets?
The need for continued Fed restraint and the likelihood of a bumpy landing favor bonds over stocks. Fading growth and rising unemployment by year end will force the Fed to relent, creating the conditions for interest rates to fall. Short-term interest rates will fall more than long rates, allowing the yield curve to ‘normalize’. But weaker growth and rising unemployment suggest downside risks to growth and corporate profits, posing challenges to the recovery of equity markets. Much of this year is likely to be characterized by uneven and volatile stock market performance.
Unhelpfully, contentious debates and posturing around the debt ceiling negotiations will last for months before a political compromise is found. That is another reason why equity markets may have a bumpy first half of the year. But ultimately, fears of a default will prove unfounded, paving the way for risk premiums to recede later in 2023.