What Everyone Got Wrong About the Economy—and the Ominous Implications for the Fed
The central bank's efforts to tame inflation haven't worked yet. More pain, and a harder landing, could lie ahead.
By Megan Cassella
It was roughly a year ago, after the Russian invasion of Ukraine caused an oil-price shock and the Federal Reserve kicked off its interest-rate-tightening campaign, that forecasters began warning in earnest that the U.S. economy was on the brink of a steep downturn.
In March 2022, Goldman Sachs economists published an economic forecast reflecting a 20% to 35% chance of an economic contraction within 12 months.
By June, JPMorgan Chase CEO Jamie Dimon was bracing for an economic “hurricane,” and the following month, the team at Bank of America predicted a mild recession would hit before the year’s close.
In September, policy makers at the Fed forecast economic growth of an anemic 0.2% for the year.
The depressing outlook dragged down consumer sentiment and convinced roughly three-quarters of Americans by late fall that the country was already in a recession.
And yet none of it came true.
Instead, consumer spending continued to rise, the unemployment rate fell below its prepandemic low, and the government reported last month that the U.S. economy grew 1% from the fourth quarter of 2021 to the fourth quarter of 2022—five times the level the central bank had predicted just a few months before.
The question of how the U.S. economy has been able to defy gravity and stave off recession has dominated the conversation among professional prognosticators and given rise to a volatile economic environment, one in which a single data release can send markets soaring one day and plunging the next.
The dynamic has left businesses struggling to figure out how to plan for the future and forced economists to examine why the combination of geopolitical tensions, inflationary pressures, and tightening monetary policy is having far less of an impact on the economy than historical precedent and conventional wisdom would suggest.
And it has heightened the stakes for the Fed, which already had a difficult task of trying to slow the economy without driving it into recession, but now has to navigate an environment unlike anything it has ever seen.
“They’re flying blind,” says Jay Bryson, chief economist with Wells Fargo. “And trying to feel their way in.”
Understanding the strength of the past year, and what has fueled it, is critical to charting the economy’s path forward. The simple answer is that it’s impossible to apply old rules to a new economy, one that has been completely—and permanently—transformed by the Covid-19 pandemic and no longer responds in the same way to rising prices and tighter monetary policy.
But the more thorough explanation, based on Barron’s interviews with nearly a dozen top academic and Wall Street economists, is that a host of factors played a role forecasters initially might have underestimated or overlooked, in part because they had never collided this way before.
The long tails of fiscal stimulus, for example, have propped up the economy for far longer than anyone expected.
Excess consumer savings and an ebullient labor market fueled demand for travel, restaurant dining, and other services, where spending still has room to grow.
And years of low interest rates have transformed the debt dynamics for the overwhelming majority of U.S. households, leaving them largely shielded, through fixed-rate mortgages, from the impacts of the Federal Reserve’s primary tightening tool.
The result is an economy that has yet to fully react to the policy tools designed to slow inflation, which more often than not have forced a recession.
The recent spate of positive economic data has fueled hopes of a “no landing” scenario, rather than a hard or soft landing, in which the economy continues to expand.
But a more realistic outlook is less benign: Interest rates are likely to stay higher for longer to tamp down stubborn price growth, probably forcing at least a mild downturn along the way.
“It’s still a story of an economy that is uncomfortably warm from the Fed’s perspective, even though it’s clearly shifting gears,” says Diane Swonk, chief economist with KPMG.
“The hard part is, you don’t want a deep freeze.
But on the other side of it, you can’t really afford a rolling boil, either.
And we’re caught in between right now.”
That means the risk of an economic recession remains on the table, and most forecasters see a downturn in the next year as more likely than not.
But those same forecasters keep pushing out the timeline for when they see the contraction starting.
And everyone acknowledges that the economy’s confounding resilience so far has underscored the unprecedented nature of the current moment.
“Everyone’s scratching their head to some extent,” says Dean Baker, a senior economist and co-founder of the Center for Economic and Policy Research.
“We all have ideas,” he says. “But we have to recognize, we’re really kind of shooting in the dark.”
When the Federal Reserve raises interest rates, it’s looking to slow consumer and business activity—and, by extension, inflation—by making things more expensive.
Big-ticket items, such as homes and cars, start to cost more because buyers are paying higher rates for their mortgage or auto loan.
But the unique structure of the 2022 economy blunted the power of the Fed’s tools.
Years of low interest rates, dating back to the aftermath of the 2008-09 financial crisis, had allowed for a transformation of much of the debt in the U.S., both household and corporate, away from variable rates that rise as the central bank tightens policy.
That meant that even as the Fed raised interest rates eight consecutive times over the past year, swaths of households and corporations were slow to feel the impact.
Consider mortgages.
Before the 2008-09 financial crisis, nearly 40% of mortgages were adjustable rate, so Fed rate hikes drove payments up and served to choke off household spending, says Ellen Zentner, chief U.S. economist at Morgan Stanley.
Today, that share is just 10%, meaning the overwhelming majority of homeowners hold mortgages at 30-year fixed rates and therefore aren’t being heavily affected by rising interest rates in the same way.
Rates on student debt payments and most auto loans are similarly locked in.
“In general, it means much less sensitivity of households to rising in interest rates,” Zentner says.
“That has been less understood.”
The changing debt profile allowed consumers, still cash-rich from the flood of fiscal stimulus unleashed in the wake of the pandemic, to keep up their soaring levels of spending on services in particular, as Americans shifted away from the goods they had been buying during Covid shutdowns.
The change in behavior is another reason the Fed‘s rate hikes appear to be having a limited impact: Consumer spending on services isn’t affected as heavily by higher rates as demand for big-ticket items and other goods.
“You don’t really care where interest rates are if you’re going out to restaurants,” Bryson says.
And because services make up roughly 60% of consumer spending, the more heavily affected goods sectors have to weaken significantly before the impact “starts to trickle back into services,” he adds.
Also propping up consumer spending is pent-up demand.
That’s partly due to the ongoing unwinding of pandemic fears and restrictions that had limited spending on services: As of December, services spending remained 1% below its prepandemic trend, a Wells Fargo analysis showed, suggesting the sector still has more room to grow.
But spending has also been fueled by excess savings—the amount of money saved beyond the typical rate—built up in part because of the more than $5 trillion the government spent on stimulus programs in response to the pandemic.
That government spending was meant more or less as an emergency buffer to get the U.S. economy back on track in 2020 and 2021 after months of shutdowns and other restrictions.
But given the sheer amount of it—a sum equivalent to roughly a quarter of U.S. gross domestic product—and given how much of it was structured as direct payments to individuals, the aid has continued to stimulate the economy years after the first packages were passed.
Some programs, such as expanded nutrition aid, are only now winding down, while other spending, including on green infrastructure initiatives, is just beginning to flow out.
“A year later, even two years later, people still had more money in the bank,” says Jason Furman, a Harvard University economist who served as a top White House economic adviser during the Obama administration.
“And we’re still spending more money because of that.”
Services industries are notoriously labor-intensive, so as consumer demand soared, employers staffed up in response.
This kicked off what some economists refer to as a virtuous cycle of recovery: More jobs pushed total income higher, which allowed for further spending and, as a result, more jobs.
Given that the U.S. has traditionally been a services-dominated economy, “we’ve been rebalancing to our sweet spot,” says Michael Gapen, chief U.S. economist with Bank of America.
“Slowing that down tends to be pretty difficult.”
There are probably other factors at play, too: A shrinking labor supply has made hiring difficult, which appears to be prompting some employers to hoard workers they might otherwise have laid off.
An undersupply of housing, in combination with fresh federal investment in infrastructure, has kept the construction industry in business even as mortgage rates spike.
Investor optimism has been helping loosen financial conditions since the fall, making it harder for the Fed to slow things down.
Each of these factors has contributed to creating an economy seemingly immune to the negative effects of high inflation and a rapid pace of monetary policy tightening, one that almost no one expected.
And it all helps to explain how an economy whose days were numbered a year ago has so far been able to avoid a long-anticipated recession.
“It’s why the Fed has been more aggressive than at any time in its past,” Zentner says, “and it hasn’t killed the economy.”
The continued resilience has shifted the focus among investors in recent weeks away from fears of a recessionary hard landing and toward hopes of a no-landing scenario—one in which growth simply never slows down.
Not every sector of the economy is soaring: Manufacturing, for example, has contracted for three straight months.
Retail sales, despite a big jump in January, have more or less been moving sideways.
The interest-rate-sensitive housing sector has been plunging, though there are some reasons to believe that it could be turning a corner.
But remarkable strength remains the more dominant story, and the arguments in favor of the no-landing view encompass many of the fundamentals that have carried the economy so far.
Consumers, broadly speaking, remain healthy.
Excess savings, though somewhat depleted, will continue to fuel spending through at least the first half of this year for the lowest-income households, and through the end of next year for middle-income groups, according to estimates from Morgan Stanley.
And the labor market shows almost no signs of cracking, having added more than a half-million new jobs in January alone.
What the no-landing scenario fails to address, however, is that at a certain point, persistent strength begins to pose its own set of risks because it forces the Fed to take further action to try to rein in inflation.
The latest consumer-price data show that progress on fighting inflation has slowed—the Fed’s preferred inflation gauge, for one, came in well above consensus in January—and costs in the services sector in particular are continuing to rise despite the central bank’s actions.
There is more to do.
A no-landing scenario, in other words, is simply a delayed landing because the central bank will keep policy tight until inflation falls.
And whether it will be a contractionary crash or a smooth glide back to 2% inflation remains to be seen.
The latter option is still possible, and some forecasters say its likelihood has increased mildly after the latest batch of data.
But others feel the latest strength could tip the scales in the other direction: The harder the central bank has to work to see the cooling it wants, the higher the risk rises of a policy error that forces a recession.
Baker, for one, is predicting no downturn for 2023 as of now.
But he worries that some of the recent data, particularly the red-hot jobs numbers, could boost the chances of a Fed overreaction.
“The story of a recession would be if the Fed basically freaks out,” Baker says.
“If they go, ‘Oh my God, this is really out of control, we have to really slam on the brakes.’
That’s the biggest risk.”
Even unprecedented strength so far, then, isn’t enough to ensure the Fed can avoid the outcome most forecasters still expect.
But, then again, most forecasters expected more weakness by now, too.
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