Dragged down by inflation and supply chain woes, the U.S. economy got off to a bad start in 2022, with declining economic growth as U.S. GDP fell 1.6% in the first quarter and 0.6% in the second quarter.
However, U.S. GDP rose 3.2% in the third quarter and the latest projection from the Federal Reserve Bank of Atlanta indicates U.S. GDP rose 4.1% in the fourth quarter. But despite the improved performance for the economy in the second half of 2022, many economists are projecting a recession in 2023. Inflation remains a major problem. Although the U.S. year-over-year inflation rate dipped to 6.5% in December from its recent peak of 9.1% in June, inflation continues to eat into the purchasing power of consumers and is much higher than the 2% rate targeted by the Federal Reserve.
The Fed has been hiking interest rates since March in an attempt to fight inflation. While the dip in the inflation rate suggests some progress has been made, the full impact of rising interest rates could be felt in 2023 as more expensive borrowing costs slows economic activity.
Meanwhile, the labor market remains extremely tight with the U.S. unemployment rate at 3.5%. That’s good news for workers, obviously, and the healthy labor market could be the most important factor to help the economy weather the storm and avoid a severe recession. But the tight labor market also continues to cause major problems for businesses that are struggling to find the workers they need, and the worker shortage is putting upward pressure on wages.
So, is it time to batten down the hatches, buckle our seat belts and prepare for economic turbulence ahead in 2023? It’s hard to say for certain.
"Normally, this looks like a sure recipe for recession if the Fed is truly intent on getting inflation down to 2% as quickly as possible. But this is not a normal (economic) cycle," said Michael Knetter, an economist and president and chief executive officer of the University of Wisconsin Foundation. "We are emerging from a global pandemic, which was a highly unusual situation. We’ve had little to no experience with how a pandemic economy evolves, and that means it is challenging to get the policy response correct and difficult to make predictions."Earlier in his career, Knetter served as a White House economic advisor for the George H.W. Bush and Bill Clinton administrations. Each year, he provides a macro economic outlook at BizTimes Media’s annual Economic Trends Event (to be held Jan. 26). He also annually participates in a Q&A interview with BizTimes Milwaukee editor Andrew Weiland for the BizTimes Milwaukee Economic Trends report (see below). "How did we get where we are today? The pandemic was first and foremost a massive negative supply shock," Knetter said. "As the virus spread, entire economies essentially shut down except for essential workers. Almost no goods and few services were able to be produced while workers stayed home and policymakers assessed the situation. Monetary and fiscal authorities responded quickly with expansionary policies that propped up asset values, kept interest rates at zero, and provided direct financial support to businesses and households beyond what was earned in employment. But no policies could fix the tangled and impaired supply chains that resulted from episodic plant closures, especially in COVID zero China, and compromised distribution networks. This negative shock to supply from the pandemic and positive shock to demand from policy choices created the foundation for future inflation. It was slow to materialize in part because people weren’t really able to go out and spend their income and wealth as the virus raged throughout 2020 and into the first half of 2021. Spending on durable goods was up but spending on services was way down. "Finally, as vaccines became more widely available and were delivered to the majority of the population, the economy began to return to some semblance of normal in the summer of 2021. But it was only a semblance of normal. There was pent up demand for travel, hotels, and dining out but it was hard to meet that demand. Many motivated workers had left that sector entirely, and it was hard to entice new workers without hefty wage increases. But households were ready to spend the savings they had accumulated as incomes, in part due to government supports, had greatly exceeded expenditures. These pent up savings also had a second order inflationary effect beyond the excess demand. Those savings, and lofty stock prices, led some workers to retire earlier than previously anticipated and led other households to reduce labor supply perhaps due to young children and uncertain day care options. Thus, even though the health risks from the pandemic had subsided, the supply side of the economy was still compromised due to reduction in labor supply. By summer of 2021, inflation began to gain momentum. The year-on-year increase in the Consumer Price Index was 1.4% in January of 2021, 5.4% by July 2021, and then 7.0% by December of 2021. "Initially, the Federal Reserve viewed the rise in inflation as caused by transitory factors related to the pandemic (the shutdowns and shortages, tangled supply chains, reduction in labor supply, and the expansionary policies) and resisted raising rates throughout 2021. Some would say this was a convenient dovish view taken while (Federal Reserve chairman Jerome) Powell was interviewing for reappointment. Once he was reappointed, the transitory talk ended and the Fed announced the intention to begin monetary tightening in early 2022 to restrain demand through higher interest rates. "Unfortunately, before those rate hikes even began, the underlying conditions got much worse with the Russian invasion of Ukraine in February of 2022 and the severe economic sanctions imposed in response. This caused a major spike in energy and commodity prices. The geopolitical fallout as countries choose their stance on the invasion only heightened trade frictions around the world and set us on a course to unwind some of the efficiency gains achieved by prior decades of global economic integration. This added to supply headwinds. "By the time the Fed raised rates by 25 basis points to put the Fed Funds range between 0.25% and 0.5% in March 2022, inflation was running at 8.5%. Then the Fed turned more aggressive with six more hikes of 50 to 75 basis points each. By December’s hike, the Fed Funds range was 4.25% to 4.5% and the inflation rate had cooled to 7.1% (the November year on year change) from a peak of 9.1% in June. "Throughout the rate hike cycle to date, the labor market has remained tight. Unemployment rates remain very low by historical standards and the labor supply is well below what would have been projected absent the pandemic. Real GDP growth languished in the first half of the year, but the third quarter estimates were quite strong. These factors mean the economy is not in recession as of the third quarter of 2022. While growth may slow in Q4, it is unlikely to be negative and the labor market is too tight for this to be considered a recession. "The tale of 2023 will turn on whether supply can make a meaningful recovery, which would reduce the need for the Fed to reduce demand. If inflation has to be reduced solely by reducing demand, then a recession seems inevitable. If the supply side of the economy could grow due to an increase in labor force participation, it might be possible to reduce inflation without causing a recession. An end to the war in Ukraine would also make things easier by reducing pressure on commodity prices. "Headwinds that might keep inflation high: (1) fiscal and monetary policy seem increasingly biased toward expansion due to political pressures, (2) the unwinding of globalization due to geopolitical tensions, (3) slower than expected growth in labor force due to personal choices and a substantial drop in immigration, and (4) the push toward decarbonization of our energy supply will be costly. "Tailwinds that might push inflation down include: (1) innovation that automates more nodes of supply chains to boost efficiency, (2) the strong dollar will help keep import prices lower in dollar terms, and (3) higher interest rates and depleted savings may curtail consumer demand, ideally in a measured way."
And now, after that lengthy recap from Knetter of the macroeconomic picture, here's his Q&A with BizTimes Media editor Andrew Weiland:
BizTimes: Let’s start at the top. Are we in a recession yet? If not, do you expect the U.S. economy to go into recession this year? If we are already in a recession, or are going to be in a recession, how long do you think it will last and how bad do you think it will be?[caption id="attachment_482868" align="alignright" width="300"] Knetter[/caption]
Knetter: “While it has become a kind of rule of thumb that two consecutive quarters of decline in real GDP constitutes a recession, that is not the actual definition used by the business cycle dating committee at the National Bureau of Economic Research. A recession is identified when a broad set of conditions occur, including declining real GDP but also elevated unemployment rates. We are not in a recession now. The economy is still growing in fits and starts, and the labor market is too strong for this to be labelled a recession.
“My best case is that we will see the economy flirt with a technical recession. Growth will weaken due to falling demand in 2023. If the supply side of the economy recovers enough, we might sneak by without a recession. But if the labor force remains below historical participation rates, the Fed will have to do more than we expect to reduce demand, and then we might see a technical recession. But I think it would be mild and brief but followed by a slower-than-normal recovery due to the headwinds facing the economy.”
BizTimes: It's probably safe to say inflation is the biggest concern with the economy. Since March, the Fed has been raising interest rates in an aggressive attempt to reduce inflation. What impact will those interest rate hikes have on the economy in 2023? How much longer do you think the Fed will continue to raise rates? Can you predict an endgame for the Fed?
Knetter: “The current guidance suggests that the Fed will hike another 75 basis points into 2023, and that seems about right to me. They should reach that target by late spring or early summer. At that point, I would guess year-on-year CPI inflation is back down below 5% maybe approaching 4%. If we get a little help from more people entering the labor force, that may help them achieve the soft landing of cooling inflation without a recession.”
BizTimes: At what point do you think inflation will slow to a healthier, more acceptable pace?
Knetter: “Sometime in 2024 I think we will be back to less than 3%, which feels acceptable.”
BizTimes: For most people, when you think of a recession, you think of people losing their jobs. But while many expect a recession in 2023, the labor market remains extremely healthy. The unemployment rate is still very low. Employers are still struggling to fill open positions. What type of recession are we going to have with such a strong job market? Have you ever seen an economic dynamic like this?
Knetter: “As I noted before, this is the first situation of its kind we have seen. An economy emerging from a global pandemic is bound to have some unusual features. And it just may be the kind of economy where the soft landing is possible.”
BizTimes: With a strong labor market and persistent inflation, what is going to happen with wages in 2023?
Knetter: “Wages will rise but the rate of increase will fall in line with the decline in inflation.”
BizTimes: What about the consumer? We are already seeing signs of consumer spending slowing. As prices continue to rise, how much more can consumers bear before they have to significantly cut back on spending? Are they eating into their savings and/or running up credit card debt to keep up with inflation?
Knetter: “Fed survey data released this fall showed that household balance sheets remained in good shape. Credit card debt balances are 10% below pre-pandemic levels. However, it will be more expensive to service that debt going forward. I think we are going to see pre-pandemic balance sheets by late spring, and that will help the economy get back to a more normal pattern.”
BizTimes: Consumer demand shifted heavily in favor of goods during the COVID-19 pandemic. Then, when vaccines became available and the pandemic waned, consumer demand for experiences exploded. What should we expect for consumer demand in 2023?
Knetter: “We should find our way back to normal spending patterns across consumption categories. The mismatch between supply and demand within categories probably contributed to inflation, and a return to normal will help things level out.”
BizTimes: Gas prices shot up in 2022, but have come back down to earth. That has to help things, right? What direction do you think gas and other energy prices are heading in 2023?
Knetter: “Energy prices are set in global markets, and it looks like a slow growth year for the global economy, so I would expect prices to remain about where they are now, absent some new shock to the system.”
BizTimes: Supply chains were thrown out of whack during the COVID-19 pandemic, contributing to inflation and causing nightmares for a number of industries, especially in manufacturing. Is the worst of that over or is there more pain to endure there?
Knetter: “The worst of the disruptions are over. Now it is more like a steady drip of turning away from global trade and the production efficiencies that it generated. This will be a moderately inflationary force.”
BizTimes: Are we in danger of serious trouble in real estate? Could rising interest rates lead to a collapse in the housing market? What about commercial real estate? With many people still working remote or in hybrid arrangements, will we see a big drop in office space demand and serious pain for office building landlords?
Knetter: “I think office space is in for the most pain, but even that is tricky. If you are hybrid, you are likely having everyone back in at least some of the same days. So, you need the same footprint, but it is grossly underutilized. Maybe WeWork flamed out a bit too soon. I think people have come to value their residential real estate more than ever. Higher rates will hurt demand but once inflation comes down, this too shall pass.”
BizTimes: How about the stock market? It was a roller coaster in 2022, but the big picture is stock market investors absorbed significant losses on the year. What’s your outlook for the stock market in 2023?
Knetter: “I will look for the market to be up modestly by the end of 2023, maybe 6%-8%. It won’t be a smooth ride. Remember that the pre-pandemic stock market was lower than the valuations we see today. On election day of 2020, the S&P 500 closed at 3,369 (it was above 4,000 earlier this month). Everyone seemed to feel that represented a great stock market at the time. So, we have now been through a pandemic, a major war in Europe, and what feels like a market meltdown, but the valuations are still better than pre-pandemic. I think we are doing OK when you take a longer view than just looking back at the peak values in late 2021.”
BizTimes: Would an end to the war in Ukraine make a big difference in the global economy?
Knetter: “It would make a huge difference to the Ukrainian people and a modest difference to the global economy if we could get back to better flows of trade in commodities especially. There also will be, sadly, major rebuilding needed in Ukraine, which will be a massive source of fiscal stimulus. This will be good for GDP growth, but of course we are just rebuilding things that Putin’s military destroyed. War destroys massive amounts of wealth.”
BizTimes: What keeps you up at night when thinking about the outlook for the U.S. economy in 2023?
Knetter: “Coffee. OK, not really. Nothing keeps me up at night regarding the outlook for the U.S. economy. What keeps me up is the geopolitical tensions and the possibility of a mistake that draws the U.S. and one or more rivals into an escalated conflict.”