The Era of Ultra-Low Interest Rates and Inflation Is Over
The market volatility that followed the failures of Silicon Valley Bank and Signature Bank in early March reinforced consensus forecasts of a recession this year and caused markets to price in significant cuts in the Fed’s policy rate by yearend. Neither is likely to happen. Instead, the economy will probably exhibit resilience in the face of a historic tightening in monetary policy and continue to grow, albeit sluggishly. Inflation should remain on a downtrend but will end the year well above the Fed’s target of 2%. As a result, the Fed is not likely to cut rates this year.
Recession forecasts are not surprising considering the vast amount of policy tightening over the past year or so. The Fed hiked rates by 500 basis points, the most significant tightening in monetary policy in more than 40 years. Fiscal policy also tightened significantly due to the expiration of the COVID relief programs: the U.S. budget deficit fell from 15 percent of GDP in 2020—the biggest since WWII—to 5.4% last year. All of that would generally be more than enough to generate a recession.
But it hasn’t happened—and probably won’t anytime soon. COVID changed the economy in ways that are cushioning the effects of policy tightening:
Unprecedented fiscal and monetary stimulus significantly improved the health of household and business balance sheets, and this has allowed spending to hold up unusually well:
Fiscal stimulus amounted to a stunning 25% of GDP, roughly seven times what was applied during the financial crisis. At the same time, bond purchases by the Fed were also significantly more extensive and made over a much shorter period. This generated a surge in household wealth, savings, spending, and, of course, inflation. While all have come off the boil, they remain relatively healthy.
The pandemic also created a massive shortage of labor due to:
- Excess deaths over 2020-22, which amounted to 1.6 million people, of which roughly half million were of prime working age.
- A surge in early retirements due to the aging of the population as well as attractive packages offered early in the pandemic by service industries struggling to survive.
- Immigration plunged by over a half million people in 2020-21.
- An unusually large number of people were sick or caring for someone who was.
The labor shortage created a record 12 million job openings, which now stand just under 10 million compared with less than 6 million unemployed. This has allowed job growth to remain strong despite declining labor demand.
While a recession will occur at some point, it’s unlikely to happen anytime soon, barring an unforeseen catastrophe. Many aspects of a typical recession have already occurred or are just underway, but they are not all happening simultaneously. The net result is an extended period of sluggish growth instead of a sharp decline in overall economic activity.
The interest-rate-sensitive sectors that usually kick off recessions—housing and manufacturing—have already experienced recession-like declines and are now bottoming. Usually this would have spread quickly to the rest of the economy through employment declines that would lead to reductions in personal income and spending, but the job shortage prevented that. In addition, just as housing and the goods economy were crashing, the services economy began a strong recovery as people resumed traveling and going out to restaurants, gyms, and spas.
While a recession seems unlikely anytime soon, neither does a strong rebound. As housing and the goods sector are starting to bottom, weakness is spreading to service industries. The tech sector is in decline after over-extending during the COVID-fueled surge in demand. The financial sector is also in a downturn. The Wall Street growth engine is sputtering as deal-making has fallen sharply after a liquidity-fueled boom. Credit conditions are tightening: deposits are declining, banks are raising deposit rates to stem the outflow, and many have largely unrealized losses on their bond portfolios. This is translating into higher lending rates and more restrictive lending standards.
With weakness now spreading to services and the more cyclical, interest rate-sensitive sectors unlikely to rebound strongly due to the persistence of higher interest rates, the overall economy is likely to continue to slog along at a sluggish pace. GDP growth has already been averaging a measly 1% since the beginning of last year.
Without discussing inflation, no analysis of where the economy and Fed policy are headed would be complete. We believe it will continue to decline but will not return to the pre-pandemic pace of sub-2% anytime soon.
Inflation surged because of severe supply bottlenecks and massive policy stimulus. The acceleration was concentrated in the goods sector since many services were off limits, where most of the supply chain difficulties were. The first phase of the decline in inflation was the reverse of that process. As people re-engaged in services, the demand for goods subsided just as supply bottlenecks started easing, causing goods prices to fall back to earth. That phase now seems to be winding down, so any further decline in inflation is likely to come from services, particularly shelter costs. They account for over 40% of core inflation and have been the largest source of upward pressure on inflation over the past year. But that is about to turn around. House prices and rents began to decline last summer after home sales collapsed, but this is just beginning to show up in the shelter component of official inflation indices because they use a 6-month average to measure monthly housing costs.
Inflation will probably settle in a 3-4% range by year-end, although a significant further decline would be difficult to achieve. Global trade—which played a key role in producing the low inflation environment—no longer expands as a percentage of world GDP.
U.S. relations with China—the world’s biggest goods exporter—continue deteriorating. Tariffs—which put upward pressure on inflation—have been maintained, and further technological space restrictions have been applied.
COVID has played a role here as well. Since the pandemic, businesses have been diversifying their supply chains and considering geopolitical and other risk factors when deciding where to produce and which countries to trade with, even if it costs more. Finally, the labor shortage has shifted bargaining power toward workers.
With recession forecasts abundant, markets are pricing in rate cuts as soon as this summer, amounting to as much as 75 basis points by yearend. If a recession is avoided and inflation remains well above target, the Fed will likely go on hold for an extended period, allowing the lagged effects of monetary tightening on the economy and inflation to play out.
There is a valid question as to whether the Fed would accept 3-4% inflation as the new normal or instead resume hiking rates. To get core inflation down to its 2% target, the Fed would probably have to tighten policy enough to crush the economy and generate a true recession. The cost would probably not be worth the effort.
There is nothing special about 2% inflation. It was chosen in 2012 because several other central banks chose that target before the Fed and because it is a low number but not too close to zero, which would risk deflation. When Fed Chair Volker left the Fed in August 1987, inflation was over 4%, and no one considered it a problem. Fed Chair Greenspan resisted setting an inflation target, believing it would cause more problems than it would solve. The key to inflation control is stability, not a specific level. Greenspan defined it as a state in which expected price changes do not alter household or business decisions. Nothing is inherently wrong with a 3-4% inflation as long as it’s relatively stable.
The COVID experience has resulted in higher interest rates and inflation, and the economy is coping relatively well. The markets and the Fed should get used to it.