Matt Rourke/AP Photo
A home under construction at a development in Eagleville, Pennsylvania, April 28, 2023
It’s now clear that the bout of inflation that began in 2021, and the minor reduction in GDP in the first half of 2022 (a recession in name, if not in impact), was almost exclusively the result of the COVID pandemic, the supply bottlenecks that resulted, and related changes in consumer and labor behavior that temporarily pushed up some prices. See this excellent discussion on the website of the Council of Economic Advisers.
Those who argued that the inflation was transitory were right. Transitory just took a little longer than anticipated. And President Biden’s public-investment programs were essential for keeping the recession short and bearable. Those who blamed Biden’s programs for the inflation and called for higher unemployment, such as Larry Summers, were spectacularly wrong, though they haven’t had the grace to admit their error.
The Federal Reserve, which meets this week for its annual end-of-summer conference at Jackson Hole, Wyoming, is in a quandary. The July minutes of the Federal Open Market Committee, released last Thursday, suggest a somewhat divided Fed. Some members would cease raising rates now and maybe even think about cutting them. Others want to keep open the option of raising rates at least once more. In the meantime, inflation keeps coming down.
Paul Krugman had a very instructive column the other day asking how much credit the Fed really deserves for keeping the recovery from getting too hot and thus helping to bring down inflation. He argues not very much.
The reason is that in the usual economic models, higher interest rates cause higher unemployment, which in turn reduces purchasing power and thus dampens price pressures. But in this case, unemployment did not rise; it fell. And prices fell, too. So the sources of disinflation were elsewhere, namely in the post-COVID restoration of plentiful supply and normalization of consumer behavior.
I think Krugman is mostly right. At the same time, however, the increase in short-term rates from basically zero to over 5 percent, and the resulting hike in mortgage costs from under 4 percent to over 7 percent, must have had some dampening effect.
Higher interest costs function like a surtax on anybody who borrows money. Even if they don’t increase unemployment, they raise costs and thus reduce effective demand for everyone from credit card borrowers to small businesses and prospective homeowners. One offset, as Northwestern University economist Janice Eberly has pointed out, is that the economy as a whole was less heavily indebted when the Fed started tightening than in previous cycles of interest rate hikes, so the Fed’s policy was relatively less damaging to the recovery.
This complex economic story has elements of bad news and good news.
A similar dynamic can be seen in the record number of multifamily housing units under construction right now. This shouldn’t be happening because of the higher costs of financing, and multifamily housing starts themselves have been flat for nearly two years. Units under construction are mostly an artifact of supply chain easing, bringing projects that should have been built a few years ago back online.
But there is still one core mystery that doesn’t get enough attention in all these discussions. If job creation and GDP growth are strong despite the Fed’s efforts to strangle prosperity with high interest rates, what is causing this economy to levitate so impressively?
It isn’t wage growth, which is barely positive. And despite Biden’s excellent policies to reclaim supply chains, the trade balance is pretty much unchanged in the short run.
The chronic U.S. trade deficit with the rest of the world did decline somewhat during COVID, between the fall of 2021 and the summer of 2022, but has been pretty much unchanged at about $65 billion a month for the past year. So increased exports or decreased imports are not a source of net stimulus.
There has also been a pronounced boom in manufacturing construction. Still, this can only account for about 5 percent of total GDP, and therefore cannot explain the entire picture.
What, then, is responsible for the impressive record of growth combined with declining inflation? There are two prime candidates.
One is the federal deficit, scorned by fiscal conservatives and prized by Keynesians, especially when it is used to finance public outlay and not inefficient tax cuts for the rich.
According to the Congressional Budget Office, the federal deficit was 5.2 percent of GDP in fiscal year 2022, 5.3 percent in 2023, and will be 6.1 percent in the next fiscal year, which begins October 1. That’s a lot of stimulus.
For comparative purposes, the deficit averaged 3.6 percent of GDP between 1973 and 2022.
The deficit hawks would have us believe that this red ink is leading to economic catastrophe. But the same CBO report projects that the national debt held by the public will grow only modestly, from 98 percent of GDP now to 118 percent of GDP ten years from now in 2033.
The reason is that all that spending and public investment fuels growth. CBO’s growth projections may be too conservative, showing annual growth rates at only 1.8 percent from 2028 to 2033. If growth is stronger than that, the debt ratio will be even better.
The other seldom-remarked source of economic stimulus is consumer spend-down of savings and increased use of credit cards and other forms of household debt. The U.S. net personal savings rate (savings minus borrowing) averaged below 7 percent in the five years before COVID. In April 2020, it hit an astronomical 33.8 percent, and was still over 20 percent in 2021. The reason was twofold: Anxious consumers reduced their spending, and with most in-person services like restaurants and sporting events shut down for a year or more, there was less to buy.
But since the pandemic has ebbed, people have maintained living standards by spending down savings and increasing their borrowing. This summer, the net personal savings rate has declined to below 5 percent. Meanwhile, household debt has risen to over $17 trillion, led by credit card borrowing.
One other factor that has allowed robust growth and job creation to coexist with very low price pressures is the steady increase in the rate of labor force participation. For prime-age women, the rate of participation hit an all-time record of 77.8 percent in June. As COVID has subsided, more people have returned to the labor force. They need the income. Slightly better service-sector wages have also helped attract them.
This complex economic story has elements of bad news and good news. The bad news is that despite the overall strong economy, most people aren’t that flush. Otherwise, they would not have to take more jobs or tap savings to maintain consumption. A related piece of bad news is that people can’t keep doing this indefinitely. They either run out of savings or reach the limits of their ability to borrow and to work more hours. And the pandemic-era supports to the poor—increases in food stamp benefits, higher numbers on the Medicaid rolls, and more—have all gone away.
But the good news is that the several improbable features of this economy seem to be acting in a rare combination that portends a continued recovery. The gradual disinflation, due to post-COVID increased supply, is offsetting the strong macroeconomic stimulus, enough to maintain strong growth and job creation but without triggering new inflation. The high interest rates have tempered growth just a bit, but have not done as much damage to the recovery as one might expect. And the manufacturing construction increases will, once the structures are built, translate into more production of goods, which is positive for jobs and supply chains, further benefiting the virtuous cycle.
Think of a Calder mobile. All of these factors seem to roughly balance each other, and in a most nontraditional fashion.
The economic historians will long be debating these dynamics. In the meantime, the Fed should take its foot off the brake, and Summers owes the public (and Biden) an apology.
