Is the Fed Peaking Too Soon?
The risk is that nominal spending will continue to rise faster than officials prefer.
This has been a resilient economy…it has been surprising in its resilience.
—Jerome Powell, November 1 2023
Compared to what they have had to deal with over the past two decades, Federal Reserve officials are currently faced with an enviable operating environment. The economy is growing briskly, consumers and businesses are still flush with cash, and the inflation-inducing disruptions to production, consumption, and distribution have (mostly) ended. At this point, the main challenge is calibrating policy to keep the good times going.
Market prices imply that this will require short-term interest rates to fall in the near future. The thinking seems to be that, as the economy continues to normalize, policy will not need to be as “restrictive”—to use Fed officials’ preferred term—as it is now. Failing to move rates lower (much less moving short-term rates even higher) could inadvertantly tighten financial conditions more than necessary, pushing the economy into an unneeded downturn.1
That might very well be correct, and I am loath to find myself on the other side of the collective wisdom of the world’s rates traders. But it seems at least as plausible that the risk goes the other way. After all, the hard data imply that policy has not actually been “restrictive” at all this year. Even if the problem of inflation is (mostly) on its way to being solved, underlying growth momentum is so strong that short-term interest rates may need to stay where they are—if not go even higher—simply to prevent borrowing and spending from accelerating.
Why Would (Nominal) Growth Slow?
Spending on U.S.-made goods and services rose at a blistering 9% yearly rate in 2023Q3. Even after subtracting inflation, real production rose at a 5% yearly rate. Some of that exceptional performance was likely a fluke, and should be discounted accordingly.2 But even before the most recent blowout quarter, total spending has consistently been growing at a yearly rate of a little over 6% since the middle of last summer. Moreover, inflation-adjusted spending by Americans—U.S. GDP excluding the impact of changes in inventories and the trade balance—has consistently been growing slightly faster than 3% a year in 2023Q1-Q3. By comparison, real domestic demand was rising just 0.8% a year on average in 2022Q1-Q4, even as total nominal spending and incomes were rising about 7% a year.
In other words, while there has been a significant deceleration in the rate of price increases from around 6% a year to 3% a year, the growth rate of the dollar value of spending and incomes has slowed by much less (from 7% a year to 6% a year). So far, this has translated into a massive acceleration in the growth rate of Americans’ living standards.
It would be wonderful if this benign combination of moderate inflation and strong growth persisted. Increased employment and faster productivity gains could help keep the good times going. (I recently heard an estimate that widespread use of “artificial intelligence” software could boost the average yearly productivity growth rate by 2 percentage points over the next decade, which would be huge.) But while I, like Larry Summers, think that sustained 6% nominal income growth would be desirable for many reasons, it is not obvious that this would be consistent with 2% yearly inflation over time. Even if it were, trend nominal growth at that pace does not seem consistent with average short rates of only ~4.5%.
The rejoinder is that nominal spending and income growth will continue to slow. As Fed boss Jerome Powell put it at his most recent press conference, “the full effects of our tightening have yet to be felt.” That is possible, but how would we know if it is correct? Mortgage interest rates, stock prices, and bank lending were all quick to respond to changes in Fed policy in 2022, and the transmission from there to both transaction volumes for existing homes and the pace of home price growth (for a while, anyway) was quick. More recently, asset returns have been strong, real activity has continued to hum, and nominal incomes have been rising steadily.
The data cannot tell us what will happen, only what has already happened. But unless there are identifiably unsustainable and/or mean-reverting forces at work, it is usually reasonable to bet that the near future will resemble the recent past. Given that, I can think of two basic reasons why the (simple-minded) benign forecast that we will stay in a world with 6% nominal and 3% real growth might not turn out to be correct:
Financial constraints force nominal spending to slow
Real constraints worsen the tradeoff between total spending and inflation
The rest of this note will look into these two potential risks. The short version is that while real growth may slow, it is much less clear why nominal growth would slow.
U.S. Consumers Are Not Under Pressure
As has been the case throughout the past few tumultuous years, American workers’ aggregate wage income has been growing in line with their spending on goods and services.