COVID-19 and the subsequent policy stimulus have led to a business cycle that defies conventional expectations, continuing to surprise even the most seasoned analysts. Given the Federal Reserve’s decision to raise interest rates from zero to over 5% between March 2022 and July 2023, a recession was widely anticipated. However, the U.S. economy defied these predictions, growing by more than 2% in the first half of last year and accelerating to over 4% in the second half. This surge in growth, typically associated with higher inflation, was accompanied by a significant decline in inflation, reaching the Fed’s target of 2% over the final six months of 2023. The unexpected drop in inflation led to a sharp decrease in interest rates, but the economy’s robustness prevented the Fed from making any changes.
However, the dynamics have shifted this year. While growth has decelerated from the rapid pace of last summer and fall, inflation has surged, surpassing the Fed’s target. The most notable change is the Fed’s stance on rate cuts, which is now driven by the high inflation rate, not the state of the economy. It is expected that the Fed will maintain its current position at least until summer and possibly into the fall, with the potential for one or even two quarter-point cuts before the end of the year.
After Dropping Sharply, Inflation Rebounds
Inflation peaked in the summer of 2022 at around 9% for the CPI and a little over 7% for the personal consumption expenditure deflator (PCE), the Fed’s preferred measure. It dropped to 2% in the second half of last year and has rebounded to over 4% so far this year. These ups and downs are explained mainly by the behavior of goods prices, which account for around 40% of inflation measures (the rest is services). They soared during the highly infectious and deadly phase of COVID-19 when people were stuck at home and avoided services such as traveling and going out to restaurants and entertainment venues. Consumers bought lots of furniture and office supplies, electronics, and exercise equipment to make home life more comfortable and accommodate working from home. This occurred just as the virus generated massive global supply bottlenecks. The combination of explosive demand and a sharp reduction in supply produced a surge in goods prices that brought inflation to levels not seen in over 40 years.
A sharp drop in inflation occurred after vaccinations increased and the health effects of the virus faded. Goods spending declined as people began to go out and about again and reengage in previously off-limit services. By the time the second half of last year rolled around, supply chains had returned to normal, and goods prices had fallen back to earth. This produced a significant decline in overall inflation.
The drop in goods prices is now mostly over. Meanwhile, the service sector has been on fire as people continue to make up for lost time by taking vacations and going to restaurants and entertainment venues in large numbers. Inflation in services has been running above 4%. The outright decline in goods prices brought inflation down to 2%, but overall inflation has moved back up now that goods prices are stabilizing.
Economic policy has also played a vital role in the gyrations of both inflation and growth since COVID-19 struck. Historic monetary and fiscal stimulus generated a powerful rebound after the economy collapsed in the spring of 2020. Without that impetus, the economy would have remained in a very depressed condition for much longer, and inflation would not have risen by nearly as much, if at all.
Economic Growth Is Slowing After a Strong 2023
Fiscal stimulus amounted to over $5 trillion, more than five times what was applied in response to the financial crisis. Monetary policy was also much more stimulative, with quantitative easing (QE) employed again, but this time much more quickly and in larger quantities. Following a collapse in economic activity in February 2020 that saw the unemployment rate soar from 3.5 to 14.7% in a mere two months, the economy rebounded strongly and quickly. The COVID-19 stimulus policies lasted for years and created more than $2 trillion in excess savings as well as strong profits. COVID also generated a massive shortage of labor, allowing strong job growth to continue even as the housing and manufacturing sectors were crushed by the sharp rise in Fed policy rates.
The increase in wealth and income provided by strong job growth and massive policy stimulus allowed consumers and businesses to continue spending throughout last year, even in the face of historic monetary tightening and the expiration of the various COVID stimulus plans. The slowdown in growth this year reflects a cooling labor market as well as the dwindling of excess savings, which have mostly been drawn down. Strong job growth and an increase in labor supply, mostly due to increased immigration, have eased job shortages, and growth in payrolls is now slowing. The unemployment rate is edging up, and unemployment insurance claims are beginning to rise from very low levels. All of this has produced a slower pace of consumer and business spending.
What we are experiencing now can be characterized as a normalization of the business cycle following the sharp swings caused by COVID-19 and the policies enacted in response. There are no signs of an imminent recession at this point, but GDP will probably grow at a pace of 2-2.5% this year, well below last year’s 3.2% pace.
The Era of Unusually Low Interest Rates Is Over
The important question now, of course, is where we go from here. We are in a different economic environment than we experienced before COVID. Following the financial crisis, inflation and interest rates were unusually low, averaging less than 2% for inflation and under 1% for the Fed’s policy rate. Before that, inflation was in a 2-4% range, and the Fed funds rate averaged around 4%. Several factors that kept inflation below 2%—such as increasingly free trade and just-in-time inventories—are now moving in the opposite direction. Tariffs and trade restrictions are the order of the day, and firms are maintaining higher inventories in the wake of the COVID-induced shortages. Businesses are also diversifying their supply chains and considering geopolitical risk and cost in deciding where to produce and source inputs. There’s also a push to produce at home.
Inflation is unlikely to get out of control, as it did during the 70s and early 80s. Technology—with investment now focused on AI—will continue to enhance productivity and provide an offset. However, inflation and interest rates should average higher levels than they did following the financial crisis. The U.S. economy has shown that it can handle policy rates much higher than the sub-1% average in the years before COVID-19.
Inflation will probably settle between 3% and 4%, and the Fed is likely to resist cutting rates for most of the year because that is above its 2% target. However, if inflation is relatively stable, the Fed will cut rates eventually, and the Federal funds rate will likely end up somewhere around 4%. With somewhat higher inflation and a much bigger budget deficit, 10-year U.S. Treasury yields should settle in a 4-5.5% range, considerably higher than the 1.5-3% range that persisted for a decade before COVID-19.
Stocks seem fairly priced despite the surge over the past year and a half, during which the S&P has risen nearly 50%. That pace is surely unsustainable, but it’s worth keeping in mind that it came after a 25% drop from December 2021 to October 2022, when a recession was widely anticipated. Recession has been avoided, and the S&P is up only around 11% over the past two and a half years. Productivity-enhancing investments in the latest AI technology should continue to boost many stocks, although a slowing economy and higher interest rates should mitigate gains in the future.
The U.S. Continues to Outperform Other Economies
The U.S. economy has been massively outperforming every other major global economy. That remains the case, but the gap is narrowing. Just as GDP growth in the U.S. is slowing, it is picking up in both the Euro area and the UK, albeit from very weak levels. Economic activity grew in Europe in the first quarter, following flat to negative activity in the second half of last year. Asia is also performing better, spurred by currency depreciation against the dollar, boosting exports.
