We are now more than three and a half years out from the start of the COVID-19 pandemic, which upended the global economy, and economists and policymakers are still surprised by the strength of the economic rebound in the United States. Most recently, both hiring and retail spending have picked up. A couple of weeks ago, the Labor Department announced that employers created three hundred and thirty-six thousand jobs last month. Earlier this week, the Census Bureau said retail sales rose by 0.7 per cent in September, on a seasonally adjusted basis, more than twice as fast as economists were expecting.
More hiring and consumer spending translate into more output. According to the Atlanta Federal Reserve’s GDPNow estimate, G.D.P. expanded at an annual rate of 5.6 per cent in the third quarter of the year, or from July 1st to September 30th. Growth rates bounce around from quarter to quarter, but that’s a big number. Next week, the Commerce Department will release its initial estimate of the actual third-quarter figure. If it’s anything like what the Atlanta Fed estimates, it will represent a significant acceleration in G.D.P. growth from the 2.1-per-cent rise in the second quarter.
The economy’s continued strength is good news for workers and businesses, and it should also be good news for President Biden, although opinion polls don’t show much evidence of that. (More on that below.) But it represents a conundrum for Jerome Powell, the chairman of the Federal Reserve, and his colleagues, who, over the past twenty months, have raised short-term interest rates from practically zero to more than five per cent, in an attempt to bring down inflation without sending the economy into the ditch. On the face of things, this policy has succeeded far beyond expectations. Between September, 2022, and last month, the headline rate of inflation fell from 8.2 per cent to 3.7 per cent. At the same time, economists’ predictions that the Fed’s policy tightening would bring about a major economic slowdown, or even a recession, have turned out to be wrong—at least so far.
Why, then, isn’t Powell declaring victory and celebrating having achieved the fabled “soft landing” for the economy? Mainly because the inflation rate is still above the Fed’s target of two per cent. The recent pickup in economic activity has defied the Fed’s own predictions and raised fears in policymaking circles that inflation could get stuck in its current range. As long as wages keep pace with price rises, that wouldn’t necessarily be a terrible thing—there’s nothing magic about the two-per-cent inflation target—but Powell and his colleagues are committed to restoring price stability.
To Powell’s credit, he has shown humility over the Fed’s failure, along with the rest of the economics profession, to predict the economy’s course. In an appearance at the Economic Club of New York on Thursday, he said, “We should be seeing the effects” of higher interest rates, but added that there is a lot of uncertainty about the lags in monetary policy. He went on: “We have models for everything. We have formulas for everything. Ultimately, as a practitioner, we have to be focussed on what the economy is telling us.”
One message the economy may well be sending is that the full impact of the Fed’s interest-rate hikes has yet to be felt, or, as Powell put it, “There may still be significant tightening in the pipeline.” Higher interest rates affect the economy through three main channels: they raise the cost of borrowing, they tend to lead to falls in asset prices, and they strengthen the dollar. So far, though, these effects have been offset by strong job growth, which feeds through into higher incomes, and the lingering impact of the pandemic stimulus programs, which boosted government spending and strengthened household finances.
In other words, the expansionary forces have outweighed the contractionary forces, but there are indications that the balance could be shifting. Even as over-all consumer spending has powered ahead, some signs of distress have emerged, including rising delinquencies on car loans and higher charge-offs on credit cards. Perhaps the most surprising economic development over the past year has been that house prices have risen despite a big jump in mortgage rates. But with the average thirty-year mortgage rate having recently risen about eight per cent, that dynamic is starting to shift. In September, the median sales price nationwide of existing homes was $394,300, down from $407,100 in August, the National Association of Realtors announced on Thursday.
Another risk factor is the possibility of a financial blowup as higher interest rates eventually bite. The S. & P. 500 index is trading about a third above its pre-pandemic level, and more than ninety per cent above its March, 2020, low. In recent weeks, long-term interest rates, which the Fed doesn’t control, have risen sharply. This development could put renewed pressure on banks, especially regional banks, which have large holdings of Treasury securities that decline in value as long-term rates rise. Then there is the commercial real-estate market, which the shift to remote work has badly hurt in many cities.
Powell said the Fed was alert to the concerns of the regional banks, and he didn’t see losses from commercial real estate “presenting much broader problems.” His broader message was that he and his colleagues are adopting a watching brief, which means they are unlikely to alter interest rates at their next meeting, two weeks away.
The Fed chair also emphasized that the policy challenges he and his colleagues are facing are a consequence of economic strength rather than weakness. Since the pandemic hit, he pointed out, the United States economy has recorded the highest growth rates of all major economies, and it has now returned to its pre-pandemic path. The unemployment rate has been below four per cent for more than a year and a half. And all this with the inflation rate having fallen dramatically.
Why isn’t this success story reflected in Biden’s ratings? Partly, it’s a consequence of political polarization. About a third of the country, or more, wouldn’t give him credit for anything. A second contributing factor could be all the media coverage over the past year about a possible recession, which never materialized. Now many economists are busy revising their growth forecasts upward, but that doesn’t get nearly as much media attention. Then there is lingering sticker shock. Even as the rate at which prices are rising has come down sharply over the past year, the actual prices of many goods are still considerably higher than they were before the pandemic. After a generation of price stability, consumers haven’t got used to that.
In theory, Powell doesn’t have to worry about politics. Next year is an election year, however, and the Fed would surely prefer to stay out of the spotlight during the campaign. Given all the uncertainty about when its policy tightening will come to an end, and the real possibility of it causing something to crack if it keeps interest rates high indefinitely, lying low doesn’t seem likely to be an option this time. ♦