July 29, 2023
Along with everyone else (okay, not Republicans), I have been celebrating the great economic news we’ve been getting the last few weeks. Inflation is clearly slowing, the unemployment rate remains low, real wages are rising, investment is growing rapidly, and the green conversion is going faster than any of us could have imagined, even if it’s nowhere near fast enough.
To be clear, we have plenty of very serious problems. Close to 40 million people still live below the poverty line and roughly that same number are close enough that paying bills every month is a huge struggle. We’ve made little progress in reducing the racial and gender gaps in wages and even less in wealth. The list is long, there are plenty of things that we should not be happy about, but for now, we seem to be making some progress.
Anyhow, when things seem to be going in the right direction, it’s a good time to ask how events can take a turn for the worse. So, here’s my list – feel free to add to it or make up your own or alter my probability assessments.
The Fed gets carried away with rate hikes, even with inflation slowing towards its target – My take on the data is that we are looking at inflation rates that are still above the Fed’s 2.0 percent target, but moving towards it. If that view is correct, the Fed would be absolutely nuts to raise rates further, at the risk of higher unemployment and financial instability, just to hasten the rate at which we reach the 2.0 percent target.
We were below the Fed’s inflation target for a whole decade following the Great Recession. Few seemed to think that was a serious problem. If it takes us another year or year and a half to see inflation fall back to the 2.0 percent target, so what?
If the point is the Fed’s credibility, it has acted aggressively to slow the economy and bring inflation back towards its target. It is hard to see anyone losing faith in the Fed’s commitment to its target if it takes until the end of 2024 or even 2025 to reach it.
Just to be clear, I’m talking about a situation where we are near 3.0 percent inflation and the direction is clearly downward. If there is reason to believe that inflation is stabilizing at a 3.0 percent rate, or even accelerating again, that is a different question.
Probability – 5.0 percent
Inflation begins to reaccelerate, leading to more aggressive action by the Fed – Virtually all the data that we have seen over the last few months indicates that inflation is slowing and will continue to slow. Two items that were huge in driving inflation, rent and vehicle prices are clearly headed downward. Non-fuel import prices, which rose rapidly in 2021 and the first half of 2022 are now falling rapidly. And wage growth has slowed sharply by every measure.
Given these clear trends, it is hard to see how we could get a resurgence of inflation, but we could try to tell a story. The Teamsters were able to secure big wage gains at UPS. There has been a lot of union organizing at Starbucks and other major companies. If increased labor militancy is able to secure larger wage gains, some of this will be passed on in higher prices. It is also possible that we will see slower productivity growth, which would also raise costs. (The second quarter productivity numbers that will be released on Thursday will be very strong.)
Anyhow, if we actually do see the downward trend in inflation reversed, it’s a safe bet that the Fed will go back to hiking rates in a big way. At some point, enough rate hikes mean a hard landing.
Probability – 5.0 percent
Republicans force large spending cuts as a condition of maintaining government funding – All the spending bills will need to be renewed by the end of September or various parts of government will shut down. House Republicans have been more focused on restricting access to abortion and beating up transgender people than budget cuts, but that could change.
The story here is straightforward. If we get large enough cuts to the budget, the economy will slow and the unemployment rate will raise. We’ve seen this movie before. This is what happened in 2011 when the House Republicans insisted on austerity to raise the debt ceiling.
Anyhow, because we saw the movie before, and President Biden played a leading role last time, we can be pretty sure it will not happen again. The budget cuts the Republicans would demand would almost certainly be unpopular. Biden would be very happy to stand tough and say no to the Republicans in this story. He is not going to accept any major cuts beyond what he agreed to in the debt ceiling deal.
Probability – 1.0 percent
Expansion of the war in Ukraine – either Russia goes nuclear or brings NATO in directly by attacking a NATO country. This is one that poses a greater threat to humanity than the economy, but if we destroy ourselves it won’t be good for the employment rate.
Probability – 5 percent
A new variant of the coronavirus that is far more harmful and vaccine-resistant – In addition to millions or 10s of millions of deaths, this could mean another round of shutdowns, putting us back where we were in 2020. From what I understand, it is unlikely that a new variant will be qualitatively worse than the current variant, but we can add this probability to the probability of an altogether new pandemic.
Probability – 1 percent
Massive Climate Event – We are already seeing horrific climate events around the planet leading to permanent damage to the environment and massive suffering, especially in developing countries. However, the economic impact, at least in the United States has been relatively limited.
That could change, but it is hard to envision a climate event in the immediate future that would have a large impact on the U.S. economy. In the past, even the strongest hurricanes and largest wildfires have had very limited effects on the economy.
Over the longer term, we do see an impact. For example, if hurricanes and flooding make it impossible for homeowners to get insurance in Florida and wildfires destroy the insurance market in California, the housing market in both states will take big hits. Of course, there are legislative fixes that can restore the insurance market through subsidies. That might be bad policy, but it will put off the reckoning being forced by these disasters.
Probability – 1.0 percent
That’s it for my list of bad stories. I am sure that I can think of some more, but I would rather not. So, all in all, I would say the near-term economic picture looks pretty good for now, even if we’re seeing absolutely horrible news on climate and pretty scary news on the war front. What did I miss?