The Big Risk is the Federal Reserve Going Too Far
While the news media keep touting the prospects for a recession, it is difficult to see why there would be one in the immediate future. To start with the basic picture, growth in the fourth quarter was a very solid 2.9 percent, following a slightly stronger 3.1 percent in the third quarter. This is very far from the negative growth we see in a recession and much more indicative of a strong economy with growth.
When we look at the individual components, the picture is somewhat mixed. Inventory accumulation accounted for half the growth, adding 1.46 percentage points to growth in the quarter. This obviously will not be sustained, and after the rapid growth in the fourth quarter, we are likely to see inventories as a drag on growth in future quarters.
With modest positive productivity growth, we can sustain a modest rate of real wage growth without causing inflation. In short, the world is looking good, we just have to keep the Fed from messing it up.
The reason for thinking the hit to growth will be much smaller in future quarters is that housing has already fallen so far. The 1.38 million rate of starts in December is roughly the same as the pre-pandemic pace. The December figure was only a small drop from the November rate, so the rapid plunges of the summer and fall seem to be behind us for the moment.
New home sales actually rose slightly in the last two months. And, with vacancy rates still near historic lows, it’s hard to envision builders cutting back on construction much further from what is already a slow pace of construction. In addition, mortgage interest rates have been falling in the last couple of months and are likely to fall further, barring a big hawkish turn by the Fed.
Another bright spot for housing is that mortgage refinancing has fallen to almost zero. The costs associated with refinancing a mortgage count as residential investment. The plunge in refinancing and new mortgages accounted for 34.6 percent of the decline in residential investment over the last year.
Non-residential investment is also likely to look better in future quarters. It rose at just a 0.7 percent annual rate in the fourth quarter. It was held down by a 3.7 percent drop in equipment investment. This component will likely turn around in 2023 due to a surge in airplane orders.
Structure investment seems to also be turning upward. There was a sharp falloff in most categories of structure investment in the pandemic, especially office buildings and hotels. These components seem to have hit bottom. A recent surge in factory construction is likely to pull this component further into positive territory in 2023. Overall structure investment grew at a 0.4 percent rate in the fourth quarter.
Consumption is the bulk of the story for GDP, and here we should see a picture of continuing modest growth. Consumption grew at a 2.1 percent rate in the fourth quarter, nearly identical to the 2.0 percent rate of the second quarter and 2.3 percent rate of the third quarter.
The data on unemployment claims indicate we are not seeing any noticeable jump in unemployment, in spite of some large layoff announcements. With a healthy pace of job growth and rising real wages, there is no reason to expect any sharp downturn in consumption.
This stable growth rate has gone along with a rebalancing of consumption back to services after a sharp rise in goods consumption during the pandemic. Goods consumption rose at a 1.1 percent annual rate in the fourth quarter after declining in the prior three quarters. Services rose at a 2.6 percent annual rate.
Goods and Pandemic
The share of goods consumption in GDP is still roughly 2.0 percentage points above its pre-pandemic level. It is likely to continue to decline modestly, with the growth in services more than offsetting it and keeping overall consumption growth in positive territory.
The drop in goods consumption will also have the benefit of leading to a smaller trade deficit. After rising sharply during the pandemic, the trade deficit has been decreasing for the last three quarters. As we see less demand for consumption goods, and also a reduction in the pace of inventory accumulation, we should see further declines in imports in 2023.
The dollar has also been dropping in the last couple of months, losing close to 10 percent of its value against the euro and other major currencies. While the dollar is still well above its pre-pandemic level, the recent drop in the dollar should help to reduce the trade deficit by making U.S. goods and services more competitive.
In addition, the fact that Europe’s economy is looking better than had been generally expected, and that China’s economy is now largely reopened, should be a boost to U.S. exports. Together, these factors should mean that the trade deficit continues to shrink and be a positive factor in growth.
The most recent data also suggest continued improvement on inflation. The core PCE rose at a 3.9 percent rate in Q4, down from 4.7 percent in Q3. This is still well above the Fed’s 2.0 percent target, but we know that rental inflation will be slowing sharply in the coming months, which will be a huge factor in lowering the core inflation rate.
Also, the fourth quarter GDP report provided more evidence to support the view that wage growth is moderating. Total labor compensation grew at a 4.9 percent annual rate in the fourth quarter. If we assume that hours grew at a 1.5 percent rate, that translates into a 3.4 percent pace of growth in average hourly compensation. This would be very much consistent with the Fed’s 2.0 percent target.
This is especially true with productivity growth in the range of 1.5 percent. After falling in the first half of 2022, productivity grew at a modest 0.8 percent rate in the third quarter. If hours growth comes to around 1.5 percent (the index of aggregate hours increased at a 1.1 percent rate, but there was a sharp rise in reported self-employment), then productivity growth should be close to 1.5 percent in the quarter.
Compared to the falling productivity in the first half, even a modest pace of positive growth will go far toward alleviating inflationary pressure. And of course, with modest positive productivity growth, we can sustain a modest rate of real wage growth without causing inflation.
In short, the world is looking good, we just have to keep the Fed from messing it up.