The recession America expected never happened.
Many economists spent early 2023 predicting a painful downturn, a view that became so widespread that some commentators began to take it for granted. Inflation had risen to its highest level in decades, and a number of forecasters said a decline in demand and a prolonged rise in unemployment would be needed to contain it.
Instead, the economy grew 3.1 percent last year, up from less than 1 percent in 2022 and faster than the five-year average before the pandemic. Inflation has fallen significantly. Unemployment remains at historic lows and consumers continue to spend even though Federal Reserve interest rates are at their highest in 22 years.
The gap between doomsday predictions and the larger reality is forcing Wall Street and academia to reckon. Why have economists gotten so wrong, and what can policymakers learn from those mistakes as they try to anticipate what might come next?
It is still early to draw concrete conclusions. The economy could still slow as the Fed's rate hikes start to add up in two years. What is clear, however, is that old models of the relationship between growth and inflation did not serve as accurate guidance. Bad luck had more influence on the initial burst of inflation than some economists realized. A lot of luck helped bring the value back down, and there were other surprises along the way.
“It's not like we understood macroeconomics perfectly before, and this was a pretty unique time,” said Jason Furman, a Harvard economist and former Obama administration economic official who believed that lowering inflation would increase it would require unemployment. “Economists can learn a large, healthy dose of humility.”
Economists, of course, have a long history of making false predictions. Few saw that the global financial crisis was coming at the beginning of this century, even as the mortgage crisis that triggered it was already well underway.
Still, the recent misses have been particularly big. First, many economists ruled out the possibility of rapid inflation. As prices rose, Fed economists and professional forecasters generally expected at least a brief period of decline and a rise in unemployment. Neither has happened, at least so far.
“It was always difficult to predict what an economy would look like after a largely unprecedented pandemic,” said Matthew Luzzetti, chief economist at Deutsche Bank, whose team proved overly pessimistic in its recession forecast last year.
Not all economists expected a recession last year. Some rightly expected inflation to fall as the pandemic disruptions subsided. But even most of them were surprised at how little damage the Fed's rate-hiking campaign appeared to have done.
“The unemployment rate hasn’t even gone up since the Fed started tightening,” said Alan S. Blinder, a Princeton economist who served as Fed vice chairman during the last successful soft landing and was a prominent voice making the argument that another soft landing is possible. “I don’t know how many people expected this. I know I didn’t.”
The series of forecast errors began in early 2021.
That's when a handful of prominent economists, including Harvard University's Lawrence H. Summers, a former Treasury secretary, began warning that America could see a spike in inflation as the newly elected Biden administration passed a large stimulus package – including one-time checks and state and local aid – in addition to previous coronavirus aid from the Trump administration. They feared that the money would stimulate demand so much that it would drive up prices.
Many government officials and economists loudly doubted that inflation would rise, but the price rise came. Some of this was due to demand, some was due to bad luck and pandemic-related disruptions.
Stimulus funds and lifestyle changes related to the pandemic had helped boost purchases of goods at a time when the supply chains set up to deliver those products were under pressure. Shipping routes were unprepared to handle the flood of demand for sofas and fitness equipment. At the same time, manufacturers faced rolling closures due to virus outbreaks.
Russia's invasion of Ukraine in 2022 has further fueled price increases by disrupting global food and fuel supplies.
This summer, the U.S. consumer price index had peaked at an annual increase of 9.1 percent, and the Fed had begun to respond in a way that led economists to believe a recession was imminent.
Fed policymakers began a rapid series of rate hikes in March 2022. The goal was to make buying a house or car or expanding a business significantly more expensive, which in turn would slow the economy, weigh on consumer demand and force companies to stop raising prices as much.
Such forceful interest rate adjustments, intended to cool inflation, have typically triggered recessions, so forecasters began predicting a downturn.
“History has shown that the combination of those two things usually ends in a recession,” said Beth Ann Bovino, chief economist at US Bank, pointing to the combination of high inflation and interest rate hikes.
But the economy — while challenging for some families because of high prices and expensive mortgages — has never fallen off that cliff. Hiring gradually slowed. Consumer spending cooled, but in fits and starts and never abruptly. Even the interest-sensitive real estate market calmed down without a dip.
Robust government support goes some way to explaining resilience. Households were flush with savings accumulated during the pandemic, and state and local governments were slow to spend their own federal pandemic money.
At the same time, a strong labor market helped raise wages, allowing many households to weather price increases without having to make major sacrifices. Years of extremely low interest rates had also given households and businesses the ability to refinance their debt, making them less vulnerable to the Fed's campaign.
And part of the continued strength is because Fed officials were able to back down as inflation cooled before slowing the economy. They paused interest rate increases after July 2023 and left them at a range of 5.25 to 5.5 percent.
That begs the question: Why has inflation cooled even though the Fed has failed to boost growth?
Many economists previously said a sharper slowdown would likely be necessary to fully contain rapid inflation. Mr. Summers, for example, predicted that it would take years for unemployment to rise above 5 percent to bring price increases back under control.
“I believed that soft landings” were “the triumph of hope over experience,” Mr. Summers said. “This appears to be a case where hope has triumphed over experience.”
He pointed to several factors for the surprise: Among other things, the supply problems had eased more than expected.
Much of the disinflation was due to the reversal of previous losing streaks. Gas prices fell in 2023, and these lower prices spread to other industries. As supply chains healed, good prices stopped rising as quickly and, in some cases, even fell.
And there was some economic slowdown. Although unemployment remained somewhat stable, the labor market also rebalanced in other ways: in 2022, there were about two job vacancies for every available worker. It's now down to 1.4, and wage growth has slowed as employers compete less fiercely to hire people.
But this labor market adjustment was gentler than many expected. Prominent economists had questioned whether it was possible to cool conditions by reducing job vacancies without triggering a surge in unemployment.
“I would have thought it was an iron law that disinflation was painful,” said Laurence M. Ball, a Johns Hopkins economist who wrote an influential 2022 paper arguing that lowering the inflation rate is painful Inflation would likely require an increase in unemployment. “The general lesson that we never seem to fully learn is that it is very difficult to predict things and we should not be overconfident, especially when there is a very strange, historic event like Covid.”
Now the question is what this means for the coming months. Could economists be caught flat-footed again? They expect inflation to ease, growth to continue and the Fed to cut interest rates several times this year.
“We landed gently; we just have to make it to the gate,” Mr. Furman said.
Fed officials could provide insight into their own thinking at their meeting next week, which ends Wednesday. Investors expect policymakers to keep interest rates steady, but will watch a news conference with Fed Chairman Jerome H. Powell for clues about the future.