Is the economy headed for a soft landing, inflation or collapse?

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About the author: leslie lipschitzD., a former director of the International Monetary Fund Institute, has taught at Johns Hopkins University and Bowdoin College, was a visiting scholar at the Brookings Institution, and an advisor at Investec Asset Management.

“Economists are not good at forecasting,” say clowns, “especially with regard to the future.” A colleague also told me that they are not particularly good at understanding the past or explaining the present. But as Federal Reserve Chairman Jay Powell and his FOMC colleagues attempt the monetary-policy equivalent of crossing Niagara Falls on a tightrope, it is important to us who are betting on their success examining the evidence about the near future as best we can.

at A series of Barron’s comments Over the past 26 months, my views on US fiscal and monetary policies (and those of the co-authors) have been based on two points: First, reasonable monetary and fiscal policies begin with an estimate of the output gap—that is, a gap between demand and the level of output consistent with full employment of labor and capital (” potential output”). Policies that inject significant demand stimulus into an economy already close to full potential are bound to increase inflation rather than output. Second, the Covid shock was as likely to constrain supply capacity as it was to constrain demand. Recently, the shock of the Russian war has almost certainly reduced potential production in many sectors of the economy.

On this basis, fiscal policy has been profligate in an economy with very little spare capacity and facing additional new supply constraints. Monetary policy has gone beyond simply converting this financial waste to money to trigger inflation in asset prices, collapse in returns, and reduce the prices of risks. So it is not surprising that we now find ourselves in the current predicament: high inflation, low growth, and low financial asset prices.

The Q1 National Accounts “Advance Estimates” are consistent with this assessment. These are the best estimates currently available, but there are two caveats in order: The data may well see major revisions, and the traditional annual conversion of quarterly numbers means that small, possibly temporary, changes seem more significant than they may actually be. These caveats aside, real GDP He fell down 1.4% from the previous quarter, on a seasonally adjusted annual basis. However, this address number consists of two distinct components. Private consumption and fixed investment have been very strong. In the absence of compensating forces, these components of demand combined would have produced real growth of more than 3%. But supply simply cannot meet this demand, so inflation arose. Also, the Fed finally realized that this wasn’t just a passing price jump, and unveiled a series of projected interest rate increases and balance sheet cuts that contributed to the dollar’s appreciation. The appreciation of the real dollar – which includes both inflation and nominal appreciation – was a counterbalancing response to strong demand with weak production. Imports rose sharply, indicating dependence on sources other than domestic production to meet domestic demand. In short, given the limited supply—i.e., lower production—strong demand can be met only by much higher imports, lower exports, and lower inventories.

data about Consumer price inflation In April it was disappointing. The consensus expectation was that inflation would drop significantly. But, while monthly inflation was lower for the index as a whole, it was higher for core inflation (excluding food and energy), and the 12-month headline figure, at 8.3%, was very close to March’s peak.

Can much wisdom about the future be gleaned from this data? There is an understandable tendency for economic analysts to focus on the latest data and the short term. This is difficult enough given the extraordinary shocks of the past two years. But beyond the very short term, the difficulties are compounded by indications that long-term (“secular”) changes are likely to emerge. Some of these secular changes are only possibilities – for example, de-globalizing trade and ending wage pressure caused by the integration of Chinese and Indian workers into the global economy. Others seem inevitable – for example, population aging in most advanced economies and China and, at a more fundamental level, the many effects of climate change and policies to contain it. In any case, the implications of this are extremely significant and ungovernable.

Aside from these important issues that seem very difficult to incorporate into any short-term outlook, what might current developments portend and how can a smooth landing be achieved? There are a few alternative accounts for the next two years that seem plausible.

In terms of inflation and growth, much will depend on wage developments and supply conditions. So far, inflation has exceeded wage increase So real wages are declining. Increased wage adjustments – not out of the question given the current labor shortage – will support demand, but given global supply conditions, will trigger a new wave of inflation and a more aggressive tightening of monetary policy. The debate about the “neutral” nominal fed funds rate is a ridiculous one: as long as real interest rates are negative, there are no real demand constraints that stem from monetary policy…except, perhaps, through asset prices. Herein lies the central dilemma of the Federal Reserve. If price increases and quantitative tightening are too slow, it will not constrain the price inflation of goods and services. On the other hand, if the tightening is fast enough to constrain demand, it could lead to a collapse in a wide range of asset prices, and financial turmoil that would move from Wall Street to Main Street and lead to a severe recession.

Here are three reasonable scenarios.

Scenario 1 (most optimistic): Fed tightening is enough to contain wage pressure and gradually reduce inflation while avoiding financial meltdown. Despite the decline in real wages, the growth of private consumption continues, albeit at a somewhat weaker pace, through the decrease of high accumulated savings. A period of weaker growth and lower inflation ensued.

Scenario Two: Wage and price pressures force the Fed to take a more aggressive tightening stance. Asset prices fall and remain low for some time; Financial turmoil is driven by a lack of liquidity and a jump in the spreads of junk loans and bonds; Sovereign defaults in emerging market economies and financial financing difficulties in some advanced economies add to global risk aversion and a less benign external environment; The collapse of domestic demand is transmitted from interest-sensitive sectors to the economy as a whole. Recession puts an end to inflation, but at a great cost in terms of lost production and wealth.

Scenario Three: Fed tightening weakens interest-sensitive sectors of the economy and dampens asset markets, but a systemic financial meltdown is avoided. persistent inflation leads to a decrease in family income, which, together with a rise in financing costs and a decline in financial wealth, leads to a decrease in consumption; Fixed investment falls with anemic probabilities of consumption. The economy is entering a period of low growth or stagnation along with persistent inflation well above the 2% target.

Remember the picture of Powell and his colleagues trying to cross Niagara Falls. The first scenario is the things that make up hopes and dreams; They made it all the way. The second scenario falls out of this tightrope: the stuff of policymakers’ nightmares. My bet at the moment is on the third scenario: stagflation. But with the world repeatedly hit with the kinds of unpredictable shocks, with unfavorable secular trends, and ill-considered political responses, things could get worse.

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