Midyear Economic Outlook
A leading error you’ll see in economic analysis, usually among crackpot Austrian types or amateurs, is to treat the economy as an automatonistic system. As a system “fully determined”, that no matter how complicated, it ultimately follows certain rules that can be readily understood and used for forecasting. This usually takes the form of “the USA will have hyperinflation” or “the USA will have a colossal recession”. When the reality is that, while both outcomes might prove true, it’s hardly “baked into the cake”.
The mark of a mature macro commentator is to add a new layer to his/her preferred basic macro model: the role of the policy maker. Once the human element is added, things become wildly unpredictable. Let’s take the example of post-Qing China. If you’d been asked in 1935 to qualitatively describe China’s prospects for the next few decades, you’d be optimistic. One of three things would happen:
The status quo of division under the Nationalist KMT and Japanese would continue
The Nationalists would takeover all China
The Japanese would takeover most of China
Sure the land might be ravaged by war, but by 1960 or 1970, China should be on her way to prosperity, just extrapolating from the progress the KMT and Japanese occupation in Manchuria had accomplished by 1935. Your optimistic forecast would’ve been wrong of course, because of the essentially unforecastable human element. Basically the unique abilities and personality of the Great Helmsman, Chairman Mao, would have rendered the obvious baseline forecast grossly wrong: China would be stuck in the worst levels of poverty in 1970. Mao was so talented, he was able to set back even China by decades.
That’s an extreme example, but even if we assume rough political stability, and seek only to anticipate economic events on a short time horizon, the human element is potentially decisive. In a modern economy, dominated by sticky prices, the will of a few individuals in monetary authority, determine the fate of us all.
More than a year ago I treated the economy as functionally deterministic. I assumed the Fed would act like a programmed robot, or at least like reasonable responsible, pro-social functionaries who care about their legacy. I foresaw the Fed tightening policy and not allowing market inflation expectations to hold above 2%. They hadn’t done so since Greenspan, after all. Sadly, it was I who was behaving like a robot, trained on the 2009-2019 dataset. I dismissed the possibility the Fed would tolerate expected inflation right at 2%, and it certainly never occurred to me they be willing to see inflation expectations break 3% and hold around that level for months. Yet here we are.
The level of US GDP* is 3% to 5% above any plausible trend path extrapolated from the ‘post-great-recession’ but ‘pre-crona’ epoch. Since about mid-2021 markets, households, and firms have implicitly assumed a 6% to 7% trend GDP growth rate for the near future, when the sustainable rate is more like 4%. Expectations have cratered in the last two months, and we now face the prospect of discovering how a year+ of overly bullish and inflationary investment, consumption and hiring decisions fare in the face of rapidly falling nominal income growth.
[*By “GDP” I mean nominal GDP, the measured, seasonally adjusted level of final spending, not the useful statistical fiction of real GDP]
It was implausible the Fed would ever sustain 6% GDP growth beyond 2022, as that implies about 4% inflation, a political impossibility. Of course it was also implausible they’d ever let GDP grow at 6% after we’d already gotten back on GDP trend, and had rising inflation and low unemployment. In any case, the pressure is on, and they seem determined to deal with the inflation issue. The way back to normal inflation is straightforward, and the Fed is moving in the right direction. We need to briskly bring down the rate of GDP growth from 6.5% annualized last quarter (2022Q1), to around 0% to 1% in coming quarters, and hold it there until GDP is back on a plausible trend path.
Recessions happen when GDP falls sufficiently short of the established trend path. This is why we hardly had any recession during the Corona panic; the Fed was able to maintain expectations that we’d return to the pre-Corona GDP trend. However, the Fed has been busy establishing a new GDP path in people’s minds the last 18 months, we may well have a meaningful recession as we move back to the old trend.
The plot below shows what I have in mind, and essentially what I think the Fed will do.
The “Trend” series I’ve plotted shows a 4% yearly extrapolation of GDP from Q4 of 2019. This is probably close to the optimizing path for the USA. The blue line shows empirically measured GDP (which is just an estimate and I think will turn out to be somewhat below true GDP, will find out in a few months when the figures are comprehensively revised). The dashed black line shows what the Fed should do: give us about 1% annualized final spending growth for the rest of the year. That should get us back to trend, and from there the Fed can glide us to a reasonable path forward, at 4% per year.
The Big Risk
The Fed can’t really do anything about supply side shocks. If the Europeans decide their Russian oil should be delivered by tanker, and blended with 10% Saudi oil, instead of by pipeline so they can tell themselves it’s not Russian, well then European potential real output will be cut. Tankers are more expensive than pipelines. That’s a supply-side shock to then entire global economy.
If the Chinese repeatedly shutdown Shanghai under Corona restrictions, that probably has a globally meaningful effect. We’re still working through the hangover of lost factory output in 2020, a flood of sudden Boomer retirements, and are plagued by various social and public health (SADS) anomalies that cropped up, or became more acute following 2020.
The supply side of the economy, the useful statistical fiction that governs the theoretical maximum capacity of output, has been somewhat damaged. This means even if the Fed gets us back on a pre-corona GDP trend, inflation is likely to be above their 2% target. If in mid-2023, we see inflation numbers around 2.7%, while GDP is right where it needs to be, then the risk of recession, or 2015-style stagnation becomes plausible, though only due to the “human factor”.
We should worry that the Fed, seeing inflation 0.7 percentage point above target, shaves an additional percentage point off GDP growth, bringing us from 4% to 3%, in an effort to get from 2.7% inflation, to 1.7%. That may cause a mild recession, certainly a period of minimal growth and hiring, comparable to 2014-2016. Who knows, the 2008-2009 recession was made massively worse by Ben Bernanke’s incompetent attempts to tamp down a mild, oil-supply-driven inflation problem in summer 2008. He thought he was seeing a financial crisis caused by mortgage back securities, instead he was personally causing a cataclysmic downturn in an effort to make the inflation statistics look better.
I’ve just laid out my baseline outlook. The Fed get’s us back to trend GDP in the second half of 2022, and then in 2023 we’re at risk of them driving us into a mild recession as they seek ever-lower inflation statistics. Many such cases. In the end, no one with only public information can really say, as we’re ultimately trying to anticipate the actions of central bankers who have a broad field for action and little accountability. I will make the following call: barring a broader European war, or massive Antibody Dependent Enhancement fatalities, we are at, or near peak inflation. Look for inflation to come back toward normal levels in the second half, and into 2023. I will be accumulating cash until the 5-year TIPS spread is below 2.5%, though as always I will never sell anything I’ve already bought.