The recession America was expecting never happened.
Many economists spent the start of 2023 predicting a painful recession, a view so widespread that some commentators have begun to treat it as fact. Inflation had reached its highest level in decades, and a number of forecasters thought that a decline in demand and a prolonged rise in unemployment would be needed to counteract it.
Instead, the economy grew 3.1% last year, compared with less than 1% in 2022 and faster than the average of the five years before the pandemic. Inflation has declined substantially. Unemployment remains at historic lows and consumers continue to spend even with Federal Reserve interest rates at 22-year highs.
The gap between apocalyptic predictions and golden age reality is forcing a reckoning on Wall Street and academia. Why did economists get it so wrong, and what can policymakers learn from these mistakes as they try to anticipate what might come next?
It is too early to draw definitive conclusions. The economy may yet slow as two years of Fed rate hikes begin to add up. But what is clear is that old models of the relationship between growth and inflation did not serve as accurate guides. Bad luck contributed more to the initial burst of inflation than some economists had predicted. Luck helped lower it again and other surprises arose along the way.
“It’s not like we fully understood macroeconomics before, and this has been a very unique time,” said Jason Furman, a Harvard economist and former Obama administration economic official, who thought lowering inflation would require higher unemployment . “Economists can learn a huge, healthy dose of humility.”
Economists, of course, have a long history of making mistakes in their forecasts. Few predicted that the global financial crisis would arrive early this century, even when the mortgage collapse that triggered it was well underway.
However, the recent shortcomings have been particularly large. First, many economists have dismissed the possibility of rapid inflation. When prices took off, Fed economists and professional forecasters widely expected at least a brief period of contraction and rising unemployment. Neither has materialized, at least so far.
“It was always going to be difficult to predict what an economy emerging from a mostly unprecedented pandemic would look like,” said Matthew Luzzetti, chief economist at Deutsche Bank, whose recession forecasts last year proved too pessimistic.
Not all economists expected a recession last year. Some expected, rightly, inflation to decline as pandemic-related disruptions eased. But even most of them were surprised by how little damage the Fed’s rate hike campaign appears to have done.
“The unemployment rate hasn’t even gone up since the Fed started tightening,” said Alan S. Blinder, a Princeton economist who was Fed vice chair during the last successful soft landing and who was a leading voice supporting the possibility of another soft landing. . “I don’t know how many people expected this. I know, I didn’t.”
The series of forecast errors began in early 2021.
Then, a handful of prominent economists, including Harvard’s Lawrence H. Summers, a former Treasury secretary, began warning that America could experience rising inflation as the newly elected Biden administration enacts a large stimulus package — including one-time checks and state and local aid, on top of the Trump administration’s previous coronavirus aid. They feared that the money would fuel so much demand that it would push prices higher.
Many government officials and economists highly doubted that inflation would rise, but the price collapse came. Some of it was demand, some of it was due to bad luck and disruptions from the pandemic.
Pandemic-related monetary stimulus and lifestyle changes helped fuel the purchase of goods at a time when supply chains set up to deliver such products were under pressure. Shipping routes were not prepared to handle the deluge of demand for sofas and gym equipment. At the same time, manufacturers have faced progressive closures due to the virus outbreak.
Russia’s invasion of Ukraine in 2022 further fueled the price jump by disrupting global supplies of food and fuel.
By that summer, the U.S. consumer price index had peaked at an annual increase of 9.1%, and the Fed had begun to respond in a way that made economists think a recession was imminent.
In March 2022, Fed policymakers began what quickly became a rapid series of rate hikes. The goal was to make buying a house or a car or expanding a business significantly more expensive, which would in turn slow the economy, weigh on consumer demand and force companies to stop raising their costs so much. prices.
Such drastic rate adjustments aimed at cooling inflation have generally spurred recessions, so forecasters have begun predicting a downturn.
“History has shown that these two things combined usually end in recession,” said Beth Ann Bovino, chief economist at U.S. Bank, referring to the combination of high inflation and rate increases.
But the economy – while difficult for some families, amid high prices and expensive mortgages – has never fallen off that cliff. Hiring has gradually slowed. Consumer spending has cooled, but in fits and starts and never abruptly. The real estate market, sensitive to interest rates, also stabilized without weakening.
Robust government support helps explain some of the resilience. Families were flush with savings accumulated during the pandemic, and state and local authorities were only slowly spending pandemic-related government money.
At the same time, a strong job market has helped boost wages, allowing many families to weather price increases without having to cut back much. Years of extremely low interest rates have also given families and businesses the ability to refinance their debts, making them less susceptible to the Fed’s campaign.
And part of the persistent strength is because as inflation cools, Fed officials may backtrack before crushing the economy. They suspended rate increases after July 2023, leaving them in a range of 5.25 to 5.5%.
This raises a question: Why has inflation cooled even though the Fed stopped short of slowing growth?
Many economists in the past believed that a steeper slowdown would likely be needed to completely eliminate rapid inflation. Summers, for example, predicted that it would take years of unemployment above 5% to bring price increases under control.
“I was of the opinion that soft landings” were “the triumph of hope over experience,” Summers said. “It seems like a case where hope triumphed over experience.”
He highlighted several factors behind the surprise: among them, supply problems have eased more than he expected.
Much of the disinflation resulted from a reversal of previous bad luck. Gas prices fell in 2023, and those lower prices have spread to other industries as well. The cleanup of supply chains has allowed good prices to stop rising as quickly and, in some cases, to fall.
And there has been some economic cooling. While unemployment remained fairly stable, the job market rebalanced in other ways: In 2022, there were about two jobs for every available worker. Today they are down to 1.4, and wage growth has cooled as employers compete less fiercely to hire.
But the labor market adjustment has been more moderate than many expected. Prominent economists doubted that it would be possible to cool the situation by cutting job opportunities without also causing a spike in unemployment.
“I would have thought it was an iron law that disinflation is painful,” said Laurence M. Ball, a Johns Hopkins economist and author of an influential 2022 paper in which he argued that reducing inflation would probably require raising inflation. unemployment. “The broader lesson, which we never seem to fully learn, is that it is very difficult to predict things and we should not be too confident, especially when a very strange historical event like Covid occurs.”
Now, the question is what this will mean for the months ahead. Could economists be caught by surprise again? They expect moderate inflation, continued growth and several rate cuts from the Fed this year.
“We landed softly; we just need to get to the gate,” Mr. Furman said.
Fed officials may explain their view at next week’s meeting, which ends on Wednesday. Investors expect policymakers to keep interest rates stable, but will watch a news conference with Jerome H. Powell, the Fed chair, for any indication of the future.