Many attendees of the three-day annual conference of the economics profession, which concluded on Sunday in San Antonio, acknowledged the challenges they have encountered in projecting the future of the economy and inflation in the post-pandemic environment. Many people thought it would take a recession to bring inflation back down after failing to predict that it would spike to multi-decade highs.
Professor James Hines of the University of Michigan stated, “We didn’t really understand why inflation spiked in the first place.” “It came down faster than we anticipated, so maybe we shouldn’t have been surprised.”
The Fed’s preferred inflation indicator fell to 2.6% in November from a peak of 7.1% in June 2022, inspiring optimism among Texas-based analysts that inflation will rise again.
Professor Emi Nakamura of the University of California, Berkeley stated, “I think we should be humble about it because turning points are hard to forecast.” “At this point, it’s pretty plausible,” however.
It would be beneficial information for President Joe Biden. His poll numbers have declined due to voter unease over an increase in the cost of living, and if the US entered a recession in November, he would have greater difficulty securing reelection.
Economists at the American Economic Association convention said that the Fed should be able to cut interest rates due to the decreasing price pressure, albeit maybe not as soon as investors had anticipated.
Federal funds futures market participants are placing bets that the first rate cut by the Fed will occur in March and that rates would drop to about 4% by the end of the year. The current funds rate target range set by the Fed is 5.25 to 5.5%.
Rate Reductions
Ellen Zentner, the top US economist at Morgan Stanley, assured the gathering, “Make no mistake, they will be cutting rates this year.” However, “they can take their time and be patient.” June is when she expects the Fed will decrease interest rates for the first time.
John Taylor, a professor at Stanford University, criticised the Fed harshly for its early hesitation to limit lending and said that the bank is now far less behind the curve in battling inflation.
“We’ll have lower interest rates” if inflation keeps declining, according to Taylor, whose name-brand economic principle serves as a guide for monetary policy at central banks. He speculated that rates would eventually drop to 3% or 4%.
That does not imply an easy ride ahead. The biggest danger is a geopolitical shock, such an intensification of the Middle East conflict that drives up oil prices.
According to Ricardo Reis of the London School of Economics, that may upset still-fragile inflation expectations and raise the possibility of a repeat of the kind of inflationary spiral that led to the severe recession of the 1970s.
He declared, “I believe we’re just one shock away from having a permanent problem.” However, he gave such a slim likelihood of occurring and otherwise expressed confidence that inflation will return to 2% even by year’s end.
Model Dependence
Professor Janice Eberly of Northwestern University addressed the conference in a post-mortem on the mistakes made by economists the previous year, pointing out that the field depended too much on computer models based on historical economic linkages. They proposed that, as happened in the 1970s, a recession would be necessary to break the back of inflation.
The former US Treasury official stated, “We should never have trusted our models,” particularly after a once-in-a-century epidemic. She added that she had thought at the time that the projections were overly gloomy. “Drastic simplifications are what models are.”
Martin Uribe of Columbia University suggested expanding the time period covered by the models to pre-World War II, when inflation spikes were more frequent and a pandemic had already occurred, in a paper he gave to the conference.
An expansion on the so-called supply side of the economy has been a major factor in the US’s ability to avoid a recession. This is partially because supply-chain bottlenecks caused by the epidemic were untangled, which substantially increased the cost of vehicles and other items.
The stresses “were not fleeting.” They were tenacious, Eberly remarked, alluding to a discussion over the duration of the inflation spike that began in 2021. “However, they weren’t long-lasting.”
An even greater surprise to economists was the increase in the labour force due to higher immigration and labour force participation rates, especially among women.
According to Eberly, “the supply side of the economy has returned in a much more supportive way than most people had anticipated.” “That is the most encouraging aspect for a soft landing since it implies that robust growth can be sustained without driving up inflation.”