The U.S. economy has normalized after four years during which the effects COVID-19, and the policy stimulus that it generated produced an extraordinary business cycle that caught most analysts off guard. The Fed is likely to keep interest rates where they are at least through the summer, but there is now a good chance for rate cuts before yearend. While underlying inflation increased around 4% through April, prices barely rose in May and June. If inflation data remain benign for another month, the first Fed rate cut in more than four years will probably arrive in September.
The drop in inflation to the Fed’s target of 2% in the second half of last year was primarily due to a sharp decline in goods prices, which came down to earth after the Covid-induced surge. Goods prices have been stable this year. Still, they are likely to start climbing in the coming months as global manufacturing is picking up and transportation costs have risen, especially in shipping. Prices in services have exhibited a very different pattern. While goods prices were falling, services prices were rising at a 4-5% pace as people made up for lost time by reengaging in previously off-limit activities such as travel and going out to restaurants and entertainment venues in large numbers. Now that goods prices have bottomed and look as if they will begin to increase in the coming months, there are signs over the past two months that service inflation is settling down. This is especially apparent in housing services such as rent—the largest component of services inflation—as high interest rates have hammered the housing sector.
While the behavior of inflation this year has been volatile, U.S. economic growth has slowed down following the rapid 4% pace of the second half of 2023. This reflects a much less overheated labor market and the dwindling of the excess savings produced by the various Covid stimulus policies, which have been mostly drawn down. Job openings have fallen from a record 12 million to around 8 million, close to pre-pandemic levels. The ratio of job openings to the number of unemployed—a key measure of labor market tightness that had ratcheted up to 2 at one point – is now down to 1.2, within the range that prevailed before Covid. As a result, job growth has slowed this year, the unemployment rate has increased, and unemployment insurance claims have begun to rise. Meanwhile, still-high interest rates are keeping a lid on housing and manufacturing activity. All of this has produced a slower pace of consumer and business spending.
The U.S. business cycle has normalized following the sharp swings caused by COVID-19 and the policies enacted in response. There are currently no signs of an imminent recession. While growth in payrolls has slowed from an overheated pace, it is still very solid and worker income is running at a 5% pace, more than enough to maintain consumer spending. The unemployment rate has risen by more than a half percentage point, but at 4.1% remains historically low. Meanwhile, there has been an enormous increase in household wealth, reflecting rising prices of both stocks and homes.
Taking all of this into account, U.S. GDP will probably grow at a pace of around 2% this year. That’s well below last year’s 3.2% but consistent with what most economists consider the long-run trend. The combination of slower economic growth and recent signs of a sharp drop in inflation should allow the Fed to begin lowering its policy rate from the current range of 5 ¼-5 ½%, widely considered to be a restrictive level that puts downward pressure on the economy.
The important question now is where inflation will settle. The 4%-plus pace of the first quarter and the almost total lack of price increases in May and June are both almost surely exaggerations of the underlying trend. The Fed has a target of 2%, and that objective was regularly achieved between the financial crisis and the onset of Covid. However, several of the 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 levels of inventories in the wake of the Covid-induced shortages. Businesses are also diversifying their supply chains and considering geopolitical risk instead of only cost in deciding where to produce and source inputs. There’s also a push to produce at home. All of this suggests a somewhat higher rate of inflation—and thus interest rates—than we experienced in the decade or so before Covid.
Inflation is unlikely to spin out of control, as it did during the 70s and early 80s. Global trade volumes are still much higher than they were then and improvements in technology—with investment now focused on AI—should continue to enhance productivity and provide an offset. But inflation and interest rates should average higher levels than they did following the financial crisis, when the Fed’s policy rate averaged around 1%. The U.S. economy has demonstrated that it can handle policy rates much higher than that.
While it is difficult to forecast inflation with any degree of precision, a rate between 3 and 4% seems like a reasonable range for it to settle. While that is above the Fed’s 2% target it will cut rates if inflation is relatively stable and the economy grows at only a modest pace. As long as the economy doesn’t rebound once the Fed begins to cut rates—which is a possibility—the Fed will likely bring its policy rate down to 4% or less over the next year and a half. With somewhat higher inflation and significantly more outstanding federal debt, 10-year U.S. Treasury yields are likely to range from 4 to 5%, considerably higher than the 1 ½-3% that prevailed for a decade before Covid.
