I like to imagine the economy as kind of enormous, complex machine, all flywheels and belts and gears, blinking lights, dials, buttons, a couple of enormous levers. Careful observation has allowed economists to establish relationships between all the stuff the machine makes and all the things that go into it. When it starts to overheat, for example, experience suggests that central banks should start pulling on the lever that tightens everything up and slows down the gears.
But the economy isn’t a machine that obeys the laws of physics. The relationship between its inputs and actors changes over time, just as human society does. And right now, thanks to the pandemic and how advanced economies responded to it, we’re in a very strange place indeed. The typical relationships between one signal from the economy and another have diverged in surprising ways. As the Federal Reserve (and the rest of us) try to navigate this moment, here are the top paradoxes.
There will be more news later this week, but at the moment, the US labor market is tight, with just 3.6% of American workers unemployed in June. At the same time, other indicators, notably early measurements of economic production, have been slightly negative in the first half of the year, suggesting that a recession is imminent or already happening. Let’s skip the subtleties of defining what a recession is, and just note that they typically include significant job losses and high unemployment. It’s fairly astonishing to see this mixture of a strong labor market and an uncertain growth picture.
We may see people thrown out of work yet—particularly as the Federal Reserve keeps hiking interest rates—but for the last six months it’s been a big contradiction, despite the early layoffs that are popping up in places like the bubblicious technology sector. Another explanation is that companies, particularly retailers, built up large inventories when supply chains were tight and demand was high. Now, they’re selling through their stored goods without ordering more, leading to the fall in economic production.
There’s another weird wrinkle: The main way economists measure growth, Gross Domestic Product (GDP) is seeing a historically large divergence from Gross Domestic Income (GDI). While the former measure shows two consecutive quarters of falling production, the latter one was positive in the first quarter (its second quarter estimates will be released at the end of the month.) But these two different measures of economic activity should, in theory, match up. The divergence rests on technicalities in how economic activity is measured, but as early estimates are revised, there is a chance we’ll see GDP turn positive in retrospect.
The Fed has raised its primary index rate by 0.75% for two meetings in a row in order to slow inflation with the speediest interest rate hikes in decades. The results are starting to show in places like the housing market, where the average 30-year mortgage rate has gone up 2 percentage points since the beginning of the year, and home prices are beginning to fall.
But the Federal Reserve’s effort at measuring financial conditions show that after tightening for most of 2022, the trend has turned around in recent weeks, with credit now becoming slightly more available and investors paying less for risk. One counterintuitive explanation is that investors and businesses believe that a potential recession would see the Fed slow the pace of its hiking campaign. But that’s not what the Fed wants to see at all as inflation remains high, and why all signs point to more rate hikes.
In June, the University of Michigan’s survey of consumer confidence reported its lowest figure since 2012, suggesting that Americans were preparing for the worst. The director of the survey observed that “continued pessimism on both personal finances and the economy could dampen consumer spending going forward.” But last week’s measurement of actual consumer spending showed that Americans are still opening their wallets, even in real terms, as inflation eats away at their spending power: Personal consumption expenditures rose 4.3% in the first half of this year. Assessing consumer sentiment is tricky because people incorporate their feelings about the political situation as well as their household budget, but it is clear there is a disconnect between what consumers are saying and what they are doing.
It’s earnings season, and the message from business leaders is in: We’re cutting costs and raising prices to deal with inflation and prep for a coming recession. It makes sense for executives focused on the bottom line to prepare for an uncertain future. But markets aren’t taking their cues from worrywart managers, at least at the moment. Market-based measures of future inflation like the five-year breakeven (the spread between government securities that are and aren’t protected from inflation) sits at 2.5%, higher than pre-pandemic times but not by much. That suggests confidence the Fed will kill inflation, maybe if our quasi-recession becomes undeniable. And look at equity markets: The S&P 500 has risen by more than 7% since June. It’s still below the 2021 peak but not that far from the pre-pandemic trend: Investors seem to think the Fed won’t go overboard.
In 2022, the key driver of inflation has been rising fossil fuel prices. By some measures, though, the cost of oil peaked in June and has been falling, though it remains higher than in 2021. Gas prices, a key factor in how Americans experience inflation, have been falling steadily since their peak in June. Some analysts hoped that we might see that reflected in June measures of the Consumer Price Index (CPI) or the Personal Consumption Expenditures index (PCE), but both showed red-hot energy inflation. We may be seeing a lag in the data, and July’s inflation data could solve this mystery. Or, we may be seeing inflation dynamics becoming more embedded in the economy. Uh oh!
The source of all these changes is kind of obvious: A global pandemic unlike anything humanity had seen for a century, and an unprecedented response informed by decades of financial crisis fighting. The abrupt plunge in economic activity and its quick rebound, abetted by billions in government spending, led to a burst in changing demand that stressed an already brittle global production system. Russia’s invasion of Ukraine led to never-before-seen sanctions and more shocks to the economic machine.
What we’re really trying to figure out now is if the machine will return to normal, or if something fundamental has changed. These contradictory signals could straighten out as old data is revised and new measurements are made. Or, perhaps changes in global trade patterns, remote work, government spending, or the climate will drive us out of the “Great Moderation” that governed economic life in recent decades. Trying to understand the behavior of markets, consumers and businesses is always humbling, but doing so today calls for an extra dose of patience and humility.