New year, new congress, new economic risks

STANFORD — The economic, financial and political chaos of 2022 has exposed the limits of forecasting. Recall the outlook from mid-2021, when very few observers were worried about inflation (I was among the small minority that was). The “Blue Chip” consensus, reflecting the views of 50 private-sector forecasters, was that the US consumer price index would rise by just 2.5 per cent in 2022. Yet over the past year, “core” CPI, which excludes volatile food and energy prices, has risen by 6 per cent. Similarly, the US Federal Reserve’s preferred measure, the core personal consumption expenditures index, was expected to rise by just 2.7 per cent; it is up 5 per cent.

Then, when inflation did begin to surge, many insisted that it would be “transitory”. The Fed’s historically rapid tightening of monetary policy, repeatedly raising its policy rate by 75 basis points, before tempering its hikes with a 50-bps increase this month, was hardly on Fed watchers’ radar screens. In mid-2021, the three-month US Treasury bill yielded just 0.1 per cent. Today, the yield is 4.23 per cent.

Given these forecasting misfires, few in mid-2021 predicted a recession within the next few years. But now, almost 90 per cent of Blue Chip analysts expect that real (inflation-adjusted) GDP growth in 2023 will be 1 per cent or less, and about 40 per cent of that cohort puts it at zero or negative. After large gains during the lockdown year, equity markets have entered bear territory, with technology stocks taking a huge hit.

Political forecasts did not fare much better. Few predicted that right-wing governments would come to power in Sweden and Italy, or that Benyamin Netanyahu would once again become Israel’s prime minister. Most pollsters in the United States anticipated a “red wave” of Republican victories in the midterm elections. But the party lost a Senate seat and gained only a narrow majority in the House of Representatives, not least because candidates endorsed by former president Donald Trump underperformed across the board.

What about 2023? Despite all the bad recent predictions, policymakers, investors and households still need to plan for the future, which requires establishing a baseline outlook. As matters stand, the US economy is sending decidedly mixed signals. The labour market remains fairly robust. But with an unemployment rate of 3.7 per cent and 1.7 job openings for every unemployed person, businesses are struggling to find workers. And while the employment rate has returned to its pre-pandemic levels, labor force participation still lags, most worryingly among prime-age (25-54 years) males.

All told, there are roughly 1-2 million “missing workers” who presumably would be in the labour force if not for the pandemic disruptions. Some older workers who lost their jobs ended up retiring early, but others have not returned because of ongoing health concerns, a lack of childcare, expanded government relief payments that disincentivised work and raised savings (perhaps half of which have been drawn down), or changes in work-life balance preferences.

Beyond persistent inflation and tighter monetary policy, which will remain in place until there is significant progress toward the 2 per cent target rate, the single biggest factor in the 2023 outlook is how firms will respond to a likely reduction in demand. Will businesses announce substantial layoffs, as usual? Or will the difficulties in finding and retaining qualified workers lead them to sacrifice short-run profits to keep people on the payroll? (Many have already been laid off in the tech sector, but that is because those companies binge-hired in 2020 and 2021.)

The biggest negative factor, inflation, has slowly abated, but it remains several times higher than the Fed’s 2 per cent target. The question, then, is whether price stability can be quickly restored through slower demand growth, resolution of supply-chain issues, and tighter monetary policy. One major risk is that firms will raise wages to attract or retain employees, setting off a wage-price spiral. Thus far, wage growth has lagged price growth (which is why many poll respondents believe the US is already in a recession); but there is no guarantee that this trend will last.

Central-bank doctrine holds that monetary tightening operates with a long and variable lag (often 12-18 months), and that the target interest rate must rise above the expected future inflation rate for some period. Inflation in 2023 is expected to be around 4 per cent, according to the Blue Chip forecast; below 3 per cent, according to the bond market; and almost 5 per cent, according to consumer sentiment surveys.

Optimists are expecting modest additional Fed rate hikes from the current 4.25-4.5 per cent level. The Fed envisions a peak of 5.1 per cent. But hopes for some easing toward the end of next year receded this month with Fed Chair Jerome Powell’s suggestion that rate cuts (back toward 4.1 per cent) will not come until 2024. And even that schedule presupposes significant progress toward the Fed’s 2 per cent target. Such “soft landings”, with minimal job losses, are historically rare.

The even bleaker outlook for many other economies will compound the difficulty of engineering a soft landing. Against the backdrop of anemic growth or outright recession from China and Europe to developing countries in Latin America, Asia and Africa, the dollar’s continued strength is bad news for US exports.

Republicans will likely block most of US President Joe Biden’s initiatives, especially on spending, which will take fiscal pressure off the Fed’s inflation fight. They will do their best to limit the passage of new regulations, and to step up oversight of executive branch agencies.

House Republicans will pass their own conservative fiscal and domestic agenda and try to get the Senate to take up bills that will expose the Democrats’ embarrassing positions on issues such as illegal immigration, crime, spending and the like. Senate Democrats and Biden will ignore most and reciprocate, and all major legislation is likely to stall. At the end of the day, that may be a good thing, given the current Congress’s dubious legislative record, which has already proved far too costly for whatever modest benefits it provides.

Michael J. Boskin, professor of Economics at Stanford University and senior fellow at the Hoover Institution, was chairman of George H.W. Bush’s Council of Economic Advisers from 1989 to 1993. Copyright: Project Syndicate, 2022. 

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