January 29, 2023
The 2023 Forecast
In the past couple weeks I’ve presented my 2023 economic forecast to groups here in Indiana and Ohio. My short-term economic forecast through 2023 and into 2024 is similar to that of the Federal Reserve. I’m predicting the U.S. dodges a recession in 2023 and faces instead what is often called a ‘soft landing.’
There are good reasons why this forecast will be right and, of course, many reasons why it will be wrong. My forecast uses a series of equations that attempt to capture economic relationships over time. For example, I have an equation that predicts new home construction given population growth and mortgage rates. Another predicts sales of consumer durables given personal income growth and credit card rates.
These equations work well when the underlying relationships don’t change very much. Unfortunately, that’s often not the case, especially in the wake of the huge post-COVID economic swings. However, forecasting this way is helpful because it allows us to really focus on those areas that have the most uncertainty or change.
The forecast of continued growth comes from these models, not a hunch or feeling. There are a few good data points that help explain why these sorts of models would suggest we’ll dodge a recession. To begin with, the economy is currently growing well. GDP growth in the third quarter was at 3.2 percent, and the slowdown in the first half of last year was largely due to inventory adjustments. There’s nothing happening right now that would suggest an immediate slowdown.
Following some huge swings during COVID, inflation-adjusted personal income, measured on a per person basis, has been rising since June. The personal savings rate has dipped, but much of that is probably due to consumers paying off credit card debt as rates rise. Household spending on goods and services remains relatively strong. All this is encouraging news that signals a downturn is not imminent.
The reason for worry about a recession is the Federal Reserve’s response to high inflation. The tightening of the money supply, most obviously through higher interest rates, is designed to slow demand for goods. This would bring inflation back to the targeted level of between 2.0 and 2.5 percent.
The good news is that when measured from month to month, inflation has stopped. By some measure it has even slipped into deflation. While the year-to-year inflation is still high, the end of monthly inflation means that the rate should fall back to the targeted range by late spring or summer. This means the Federal Reserve can slow their efforts to stop inflation, as they seem likely to do in the coming months.
The Fed always tries to achieve a soft landing, but labor market conditions today make it easier to do so for several reasons. First, the unemployment rate remains at her historic lows. Second, the excess demand for labor, as measured by job openings, is unusually large. It is larger than at any time for which we’ve had data, and probably larger than at any time in history. While this is uncomfortable for businesses, it makes a soft landing more likely.
The Federal Reserve’s aggressive interest rate hikes have stopped inflation, without thus far increasing unemployment. The hope is that the Fed can continue to reduce the excess demand, but that reduction will be felt in the help wanted advertisements, not in actual hiring. That is the ‘soft landing.’
Even with a soft landing, there will be some labor market effects. The past few months have seen significant wage growth for workers with the lowest income. Much of this is fueled by workers changing jobs, not by general wage increases. In many industries, the only way to experience wage growth is through ‘job hopping.’ That opportunity may be coming to an end. Slack labor markets may slow the growth of remote work in some sectors, but it may grow opportunities in others. And, the end of tight labor markets might slow the pace of automation in the service sector. We won’t know how these shake out for many months.
My prediction of a soft landing is shared by the Federal Reserve forecasters, as well as many academic and commercial forecasts. Still, there are model-based forecasts of a recession in the first half of 2023, and there are several reasons why a recession could still occur.
The economy is always plagued by short-term measurement error. In fact, the initial hesitance to believe the growing risk of inflation was because of significant underestimates of labor market strength in 2021. Today, we could be underestimating inflation or overestimating the strength of labor markets. If so, both the predictions of a soft landing and an end of inflation could be mistaken. But, the risk of measurement error is symmetrical. Labor markets could be stronger, and underlying inflation could be less than we now observe in the preliminary data releases.
China has reversed course on COVID policies, and reopened their economy. This will have uncertain effects ranging from lower prices for many of their exports, to higher global mend for energy and raw materials. It is best to view this volatility from China as an uncertain global shock to supply and demand. China’s economy is troubled, and their political regime bizarrely uncertain. It is most likely that the world is turning away from that uncertainty, but the short-run effects of their reversal of their COVID policy is very uncertain.
The U.S. Congress seems poised for a showdown on the debt ceiling. Typically, these are political theater with little effect, but this time could always be different. Also, the Russo-Ukrainian war remains an uncertain cloud on the global economy. Russia is losing, badly. A loss should end the Putin regime, so the end will be risky. At the very least, we should anticipate continued volatility in energy prices. Any of these factors could push a soft landing into a full-blown recession.
Finally, even a soft landing will see substantial slowing of demand for some products. This will be concentrated in manufactured items, from RVs to appliances. Thus, some parts of the country will feel as if they are in recession. Other places will be largely untouched. If my forecast is correct, the Federal Reserve will have negotiated a difficult soft landing in the wake of difficult post-COVID volatility and inflation.
About the Author
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