In 2021, economists expected inflation to prove “transitory.” They spent much of 2022 underestimating his staying power. And they spent early 2023 predicting that the Federal Reserve’s interest rate hikes, intended to curb inflation, would plunge the economy into recession.
None of these predictions have come true.
Rapid inflation has been the order of the day for 30 months in a row. The Fed raised interest rates above 5.25 percent to curb price increases, but the economy remained surprisingly strong despite those moves. The number of Americans is larger than expected, and recent retail sales data shows consumers are still spending faster than almost anyone expected. There is currently no economic downturn in sight.
The question is why experts misjudged the pandemic and the post-pandemic economy so badly – and what that means for politics and future prospects.
Economists generally expect growth to slow late this year and early next year, driving up unemployment and gradually curbing inflation. But some said the economy has been so difficult to predict since the pandemic that they have little confidence in future forecasts.
“The forecasts were embarrassingly wrong across the entire forecasting community,” said Torsten Slok from asset manager Apollo Global Management. “We’re still trying to figure out how this new economy works.”
Economists were too optimistic about inflation.
Two major problems have made forecasts difficult since 2020. The first was the coronavirus pandemic. The world had not seen such a devastating disease since the Spanish flu in 1918, and it was difficult to predict how it would disrupt commerce and consumer behavior.
The second complication arose from financial policy. In response to the pandemic, the Trump and Biden administrations have pumped $4.6 trillion in recovery funds and stimulus into the economy. President Biden then pushed Congress to pass several bills that would provide funding to support infrastructure investment and clean energy development.
Between the Corona lockdowns and the government’s enormous response, the usual economic relationships no longer served as good guides for the future.
Let’s take inflation. Economic models suggested that there would be no sustained recovery as long as unemployment was high. It made sense: If a group of consumers were unemployed or seeing little wage growth, they would pull away if companies charged more.
But those models didn’t take into account the savings Americans accumulated through pandemic relief and months at home. Price increases began to rise in March 2021 as high demand for products such as used cars and home exercise equipment collided with global supply shortages. Unemployment was over 6 percent, but that didn’t stop buyers.
Russia’s invasion of Ukraine in February 2022 exacerbated the situation and drove up oil prices. And soon the job market had recovered and wages were rising rapidly.
They were too pessimistic about growth.
As inflation proved persistent, Fed officials began raising interest rates to cool demand — and economists began predicting that these moves would plunge the economy into recession.
Central bankers raised interest rates at a pace not seen since the 1980s, making it significantly more expensive to take out a mortgage or car loan. Many forecasters emphasized that the Fed had never changed interest rates so abruptly without triggering a downturn.
“I think it’s very tempting to make forecasts based on observations of this kind,” said Jan Hatzius, chief economist at Goldman Sachs, who has predicted a gentler slowdown. “I think that underestimates how much this cycle has changed.”
Not only has there been no recession so far, growth has also been surprisingly fast. Consumers continue to spend money on everything from Taylor Swift tickets to doggie day care. Economists have regularly predicted that America’s shoppers are on the verge of collapse, only to be proven wrong.
Part of the problem is the lack of good real-time data on consumer savings, said Karen Dynan, an economist at Harvard University.
“For months we have been telling ourselves that people at the bottom of the income distribution have exhausted their savings,” she said. “But we don’t really know.”
At the same time, the fiscal stimulus has more staying power than expected: State and local governments continue to divvy up money that was allocated to them months or years ago.
And consumers get more and better jobs, so incomes drive demand.
Economists are now wondering whether inflation can slow sufficiently without causing a decline in growth. Such a painless landing would be unusual historically, but inflation has already cooled to 3.7 percent in September from a peak of around 9 percent.
Normality may still be a long way off.
Still, that’s too fast for comfort: Inflation was around 2 percent before the pandemic. Given stubborn inflation and the economy’s resilience, interest rates may need to remain elevated to bring it fully under control. On Wall Street it even has the slogan: “Higher and longer.”
Some economists even believe that the world of low interest rates and low inflation that prevailed from around 2009 to 2020 may never return. Donald Kohn, a former Fed vice chairman, said large government deficits and the transition to green energy could keep growth and interest rates higher by stimulating demand for borrowed cash.
“My guess is that things won’t go back,” Mr. Kohn said. “But my goodness, that’s a distribution of outcomes.”
Neil Dutta, economist at Renaissance Macro, pointed out that America experienced a baby boom in the 1980s and early 1990s. These people are now getting married, buying houses and having children. Their consumption could boost growth and borrowing costs.
“For me, it’s like the old normal – the unusual thing was that time,” Mr Dutta said.
For their part, Fed officials are still predicting a return to an economy that looks like 2019. In the longer term, they expect interest rates to return to 2.5 percent. They believe inflation will ease next year and growth will cool.
The question is: what happens if they are wrong? The economy could slow more than expected as cumulative interest rate movements finally take effect. Or inflation could stall, forcing the Fed to consider higher interest rates than anyone has previously bet on. In a Bloomberg survey of nearly 60 economists, not a single person expects interest rates to be higher at the end of 2024 than at the end of this year.
Mr Slok said it was a moment of humility.
“I don’t think we have it figured out,” he said.
Audio produced by Adrienne Hurst.