What’s next for the economy? | Tom Parkin | inflammation

Thanks for such an introduction. I thought I’d take 10 minutes to share how I see the economy. I caution that these are my thoughts only and not those of anyone else at the Federal Reserve.

As you well know, the Fed has moved aggressively against inflation. We have raised 525 basis points in one and a half years. Hopefully, you’ll agree that we need to take action, because if there’s one thing we’ve learned again in the past two years, it’s that everyone hates inflation. High inflation creates uncertainty. When prices are steadily rising, it is not clear when to spend, when to save or where to invest. Inflation is exhausting. Efforts should be made to procure the best price or handle complaints from unhappy customers. And inflation feels unfair — your hard-earned raise feels like it’s being taken arbitrarily at the gas pump.

We are making real progress. In September, 12-month PCE inflation stood at 3.4 percent, down significantly from its peak of 7.1 percent in June 2022. The core was 3.7 percent, while in the last three months, the core was 2.5 percent. We have not yet reached the 2 percent target, but we are moving in the right direction.

At the same time, the data shows that the economy has been remarkably healthy. Despite fears of a recession, we continue to see strong demand and a resilient labor market. GDP grew at a remarkable 4.9 percent in the third quarter. Consumer spending was strong, up 4 percent year-on-year. Unemployment fell to 3.9 percent. Job growth averaged 204,000 over the past three months.

If you had asked me for my forecast a year ago, I would have been more than happy to see inflation at 3.4 percent and unemployment at 3.9 percent at this point. We came too soon, but the work was not done. Inflation is too high, and the central bank needs to tread a fine line. If we underestimate, as happened in the 70s, hyperinflation will return. If we overdo it, we will cause unnecessary damage to the economy. As recent news from the Middle East reminds us, even the best policy has the potential to be guided by external events.

Worth noting: Which path will the economy follow?

Our task is complicated by the extraordinarily wide range of possible paths forward for the economy—from recovery to soft landing to recession. Let’s talk about each and the policy implications.

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One path is acceleration again – demand increases and, in turn, inflation increases. Recent data often tell this story. Third-quarter GDP growth beat expectations, boosted by consumers spending pandemic-era savings and benefiting from higher wages and stock prices. A particular hot spot is the high-end experience economy. Despite a slowdown in housing activity, home prices have resumed their upward climb — evidence of continued demand amid tight supply. Construction remains strong, supported by infrastructure spending and an AI-fueled data center boom. The job market is remarkably resilient – ​​vacancies are back up, jobless claims are down and wage growth is up. This strong demand is not a solution to inflation and will require more from us.

But I don’t like relying only on data that is released late and revised many times. I make it my priority to be on the field every week in hopes of better understanding the economy.

I hear a different story on the ground. Interest-sensitive sectors such as real estate, manufacturing and contracting have reported feeling the impact of higher rates. Pandemic stimulus and excess savings have been largely curtailed. Retailers tell me that lower-income consumers are slimming down and prioritizing their spending, and middle-income consumers are trading down, perhaps still buying beef at the grocery store but school notebooks at the dollar store. Banks are feeling margin pressure and have pulled back from riskier sectors, new customers and less profitable loans. Another way to look at consumer spending is that the year-over-year growth numbers look solid but not frothy, as it seems to me that the data may show a catch-up from a weak spring.

A second possible path is the elusive „soft landing,” in which demand remains solid as inflation reaches the target. Both rate hikes and tighter credit conditions are working with a backlash and could work to lower inflation further in the coming months. Labor markets seem to be equilibrating better. Inflation expectations have been anchored, and the supply side is working to ease inflationary pressures: supply chains have mostly adjusted, gas prices have retreated from last year’s highs, productivity has risen, and prime-age labor force participation has rebounded. If all these forces continue to act to ease supply pressures, inflation may return to target without much help from us and without much damage to demand.

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But I’m still not convinced that inflation is on a smooth glide path to 2 percent. Inflation numbers have eased, but the drop is a partial reversal of Covid-19-era commodity price hikes driven by higher demand and supply shortages. Accommodation and services inflation is above historical levels. When I talk to businesses, I still hear about normal costs and price increases. Health and insurance costs are rising. Merit pools have declined, but remain above pre-pandemic levels. The latest UAW settlement could trigger another round of labor cost pressures. Big consumer goods companies in sectors like detergents, frozen foods and soft drinks are still raising prices more than before Covid-19. Without decades of pricing power, businesses aren’t going to back down from raising prices until their customers or competitors force their hand. Don’t get me wrong — a soft landing is fine. But I fear more will happen on the demand side to convince price setters that the era of inflation is over.

The third path is a shock recession, so many have been predicting for a long time. It could be driven by the central bank’s aggressive rate path, banks’ recapitalization, geopolitical events, or some new financial crisis stemming from complex sectors like commercial real estate. Such a decline usually works to reduce inflation and reverse policy, unless, of course, it emerges from a supply shock of commodities like oil.

Based on the strong data I shared, it is clear that we are not in a recession today. Because no one cancels the business cycle, someday we will be in a recession. It’s worth remembering that most recent recessions have come from unexpected events like pandemics or 9/11.

So, what path am I looking at? I expect some kind of slowdown because I have to believe that the net effect of this tightening will ultimately hit the economy harder than it should. For example, I’ve seen data showing that both corporate interest payments as a percentage of income and household interest payments as a percentage of disposable personal income have only returned to 2019 levels. These benefits of pandemic refinancing and loan repayments may not last long at current interest rates.

I see that slowly as part of what is needed to get inflation back on target. Like I said, raters have to believe. It remains to be seen whether the slowdown in deflation requires more from us, which is why I supported our decision to hold rates at our last meeting. With rates restrained and financial conditions tightening, we have time to adjust competing narratives as needed and test different views on the path of inflation.

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If we see the economy weakening, I’d say it’s worth remembering that not all recessions are created equal. We are haunted by our memories of the Great Recession and the Volcker recession, but they are particularly long and deep. As I talk to companies, I ask for reasons to believe that any fallout may be minimal this time around.

First, it will result in less displacement in the labor market. When you think of the recession, you think of the marginalization of manufacturing workers across the Rust Belt in 2008. But I’ve heard that those workers are in high demand today, as there is a shortage of workers in manufacturing plants, hotels, construction sites and restaurants. This year’s layoff announcements by major companies primarily targeted executive functions, not front-line employees. These professionals may be less inclined to file for unemployment, be out of work for shorter periods of time, and often use savings to reduce their consumption. Unemployment for college graduates is just 2.1 percent.

Second, latent demand can dampen spending slack. Houses and cars are expensive and hard to find. But if supply opens up in a weak economy, I suspect we’ll find many buyers who have been putting off purchases for the past few years and are ready to buy.

And, finally, a prolonged recession could reduce the cost of foreclosures. It’s called a much-predicted recession. Businesses plan for the fall for 18 months. They have streamlined hiring, streamlined costs, managed inventory levels and deferred investment. Banks have reduced small loans. Many consumers have tightened their belts. Therefore, if a recession comes, the economy will be less affected. If it doesn’t, today’s conservatism will fuel tomorrow’s renaissance. You could argue that the recent strength in the economy is partly supported by businesses, consumers and governments.

So, that’s how I see economics today. Thanks.

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