Happy New Year?
Bettmann Archive
I’m certainly not alone in feeling that the past few years have been a blur. It was like being on the beach and being knocked over again and again by successive waves – just when it looked like you could get up again, did another come in us?
Nobody knows for sure, of course. Who could have predicted COVID in 2020, the attack on the Capitol in 2021, or Putin’s invasion of Ukraine in 2022? But what I can say with relative confidence is that even if a new wave doesn’t unsettle us again, these catastrophic events of the past three years will continue to affect our lives in 2023.
INFLATION
The top story remains inflation. Unfortunately, although it appears to be slowing down, the underlying causes remain. These are (as I have argued elsewhere) the manufacturing and supply chain problems caused by COVID and the reduction in food and energy production as a result of the Russian invasion of Ukraine. The economics behind this is pretty simple: if you reduce the supply of a good or service while demand remains the same, the price goes up.
The table below shows the progression of inflation since COVID (CPI numbers are compound annual rates of change). As you can see, before the pandemic spread, inflation was pretty tame and even turned negative in the second quarter of 2020. Of course, that was because demand didn’t stay flat this quarter, but collapsed.
Inflation since COVID
John T Harvey
This was followed by a lockdown, which further depressed demand. However, as things started to open up again in 2021, prices accelerated. This was both because demand was recovering and, more importantly, since demand was no higher than it was in Q4 2019, supply was falling. Not only have there been sustained production cuts in several key areas like computer chips, but oil production has been reduced both by the pandemic and voluntarily.
We therefore had to endure high inflation rates throughout 2021. We all hoped for some relief in 2022 when it was assumed production levels would recover – and then Russia invaded Ukraine. This not only created uncertainty, but further reduced oil supplies and caused disruptions in grain shipments. The impact on inflation is shown above.
While December data is yet to be released, things appear to be calming down. However, 5.7% is just better, not good. You would have to go back to September 2017 to find a higher rate (6.3%) and then to February 2013 (6.7%). Why is inflation staying so high? Simple: the invasion is still ongoing and the impact of COVID is ongoing. The latter could indeed revive if the effects of China’s mismanagement of the crisis are felt.
Given all that is mine bold prediction for 2023?
- Inflation may moderate to around 4%, but the nitty-gritty problem will not go away until inventories return to pre-COVID and pre-invasion levels. There is no reason to expect this to happen very quickly or at all if Russia continues the invasion.
INTEREST CHARGES
“But,” you might say, “isn’t our government already acting boldly to try to reduce consumer price inflation?”
Unfortunately yes. What they are doing is contractionary monetary policy in the form of higher interest rates and they are likely to continue doing so for some time to come. Their logic is that if they reduce people’s incomes, it will lower inflation. That’s true enough, just look at Q2 2020 in the table above to see a quarter where prices actually fell despite COVID. It turns out that 13% unemployment can lead to deflation!
But that treats the symptom rather than the disease. It’s like putting someone with a fever caused by a deadly infection in a bathtub full of ice – yay, his temperature dropped! Now they will die nice and cool.
As explained above, the underlying issues are the bottlenecks caused by COVID and the invasion. None of these problems are in any way directly addressed by reducing Americans’ incomes. Sure, prices are going down because we don’t have that much money to buy stuff, but that’s not a solution, it’s a smoke screen. Incidentally, the policy rate – which banks offer to the most creditworthy customers – has risen to 7.5% today from 3.25% on March 14 last year. It has more than doubled in less than a year.
my bold prediction for interest in 2023:
- They will continue to rise throughout the year as the Federal Reserve dumps more gasoline on the fire in hopes it will put out the blazes. If they think the policy is working, maybe we’ll see 8.5% by the end of the summer; if not, 9.5%.
GDP GROWTH
Last summer, some concerns were raised about whether or not the US was in a recession. Those who argued “yes” pointed to the two consecutive quarters of negative real GDP growth in 2022Q1 and 2022Q2. However, this is not the official definition of a recession, just a rule of thumb suggested by economist Julius Shishkin in a 1974 article in the New York Times. The official definition leaves a lot of room for interpretation, and only one group is allowed to make that interpretation: the National Bureau of Economic Research. All in all, the discussion died down as the third quarter of 2022 actually improved significantly at 3.24%. In addition, unemployment remains below 4%.
However, that doesn’t necessarily mean we don’t have anything to worry about in 2023. What worries me more than the GDP data is the inflation-adjusted physical capital spending in our two most recent quarters, 2022Q2 and 2022Q3 (we don’t have data for 2022Q4 yet).
To give you an idea of why I’m thinking of this, take a look at the figure below, which shows the pattern of physical capital spending just before the ten post-WWII recessions (the gray areas) before COVID.
Ten Recessions After World War II.
John T Harvey
Note the pre-recession behavior of companies that have expanded their production capacity and inventories (ie investment): it is declining in almost every one. The two outstanding exceptions are recession 6, which might otherwise have been avoided had it not been for OPEC’s 1973 oil embargo, and recession 8. The latter is of particular concern right now, as it resulted from the Fed’s anti-inflationary policies, leading to key interest rates of over 20%. The result was a peak unemployment rate that remains at post-war highs except for those experienced during the COVID recession.
The situation we are facing today is that we both have declining capital expenditures and central bank policy that takes a page out of Paul Volcker’s book (Fed Chair During Recession 8 – the one named after him). That’s why I have concerns about a downturn in 2023. And while we avoided negative GDP growth in the third quarter of 2022 (after negative in the previous two quarters), this was due to fortuitous and likely unsustainable positive contributions from consumer spending and attributed to net exports. I say unsustainable because if Fed policy is successful, the former will fall and we already have signs that US trade performance suffered in the fourth quarter.
However, government spending could easily serve as a counterweight. The federal government is the only actor not faced with budget constraints, allowing it to act quickly and strategically to reverse negative trends. Of course, this would require our government leaders to cooperate and be pragmatic and genuinely care about the plight of their constituents. I don’t think anyone would disagree that we were still a long way from that before January 6, 2021.
my bold prediction for GDP growth in 2023:
- Around 2% initially and a recession at least until 2023Q3.
CONCLUSIONS
Our 2023 will be determined by our 2020, 2021, and 2022, barring the emergence of a brand new catastrophe. Inflation resulting from COVID (2020) and Putin’s invasion (2022) will be with us for some time. Worse still, it has convinced the Federal Reserve that the best course of action for now is to reduce the overall level of economic activity. This, combined with the cyclical decline in capital spending, suggests a recession may be around the corner. All of this could, of course, be at least mitigated by a determined and coherent government policy. An attempted coup (2021) and the Republican Party’s failure to elect a Speaker of the House today (the first such failure in 100 years) suggest we won’t see it anytime soon.
Perhaps worst of all, none of this even remotely addresses the real elephant in the room/existential threat, which is climate change.
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