Economists have spent 2021 expecting inflation to prove “transient.” They spent much of 2022 underestimating its persistence. And they spent the start of 2023 predicting that the Federal Reserve’s rate hikes, intended to address inflation, would plunge the economy into a recession.
None of these predictions came true.
Rapid inflation has been a reality for 30 consecutive months now. The Fed raised rates above 5.25% to curb rising prices, but the economy remained surprisingly strong despite these measures. More Americans than expected are working, and recent retail sales data show that consumers continue to spend at a faster pace than anyone expected. For the moment, no economic slowdown is in sight.
The question is why experts have rated the pandemic and post-pandemic economy so poorly – and what that means for policies and future prospects.
Economists generally expect growth to slow late this year and early next year, leading to higher unemployment and a gradual decline in inflation. But several of them said the economy has been so difficult to predict since the pandemic that they don’t have confidence in their projections.
“The forecasts have been shamefully wrong, across the forecasting community,” said Torsten Slok of Apollo Global Management Group. “We’re still trying to understand how this new economy works. »
Two major issues have made forecasting difficult since 2020. The first was the coronavirus pandemic. The world had not seen a disease of this magnitude since the Spanish flu in 1918, and it was difficult to anticipate how it would disrupt commerce and consumer behavior.
The second complication came from tax policy. The Trump and Biden administrations injected $4.6 trillion in stimulus funds into the economy in response to the pandemic. President Joe Biden then pushed Congress to approve several laws providing funding to encourage investment in infrastructure and clean energy development.
Between the coronavirus lockdown and the enormous government response, known economic relationships have ceased to be good guides for the future.
Take the example of inflation. Economic models suggested that it would not take off sustainably as long as unemployment was high. It made sense: If large numbers of consumers were out of work or getting meager pay raises, they would turn inward if companies asked them for more money.
But those models didn’t take into account the savings Americans had accumulated from help during the pandemic and months spent at home. Price increases began to be felt in March 2021, when rampant demand for products like used cars and home exercise equipment collided with global supply shortages. The unemployment rate is above 6%, but that’s not stopping buyers.
Russia’s invasion of Ukraine in February 2022 exacerbated the situation, driving up oil prices. In a short time, the job market recovered and wages rose rapidly.
As inflation took hold, Fed officials began raising interest rates to cool demand – and economists began predicting that these measures would push the economy into recession.
Central bankers have raised interest rates at a speed not seen since the 1980s, making mortgage or car loans significantly more expensive. Many forecasters have pointed out that the Fed has never changed rates so abruptly without causing a recession.
Not only did the recession not materialize, but growth was surprisingly rapid. Consumers continued to spend money on everything from Taylor Swift tickets to doggie daycare. Economists have regularly predicted that American consumers are near breaking point, but they have always been wrong.
Part of the problem is a lack of reliable, real-time data on consumer savings, says Karen Dynan, an economist at Harvard University.
“We’ve been telling ourselves for months that people at the bottom of the income scale have exhausted their savings,” she said. But we don’t really know. »
But it’s too fast to be reassuring: inflation was around 2% before the pandemic. Given the persistence of inflation and the resilience of the economy, interest rates may need to remain high to fully control it. On Wall Street, there’s even a slogan for this: “Higher for Longer.”
Some economists even believe that the low-interest-rate, low-inflation world we experienced between 2009 and 2020 may never return. Donald Kohn, a former Fed vice chairman, said large government deficits and a shift to green energy could keep growth and rates high by supporting demand for borrowed cash.
“I don’t think things are going to go back,” Kohn said. But my goodness, this is a distribution of results. »
Fed officials, for their part, continue to predict a return to an economy that resembles that of 2019. They expect rates to return to 2.5% in the long term. They think inflation will fade and growth will slow next year.
The question is what will happen if they are wrong. The economy could slow more sharply than expected as accumulated rate movements finally take hold. Or inflation could bog down, forcing the Fed to consider higher interest rates than everyone has been betting on. As part of a Bloomberg survey of around sixty economists, no one expects interest rates to be higher at the end of 2024 than at the end of this year. year.
Mr Slok said it was a moment of modesty.
“I think we haven’t found the solution yet,” he said.
