Plain English with Derek Thompson - Experts Predicted a Recession This Year. How Were They So Wrong?

Episode Date: August 8, 2023

Today’s show is about what I consider the biggest mystery of the U.S. economy. Last year, economic experts predicted a recession in 2023 with more confidence than they’ve predicted any recession in decades. We ended up with what some people are calling immaculate disinflation: an economy with low unemployment, falling inflation, rising real wages, and narrowing inequality. Harvard economist Jason Furman joins the show to talk about why so many economists were so wrong and what their wrongness teaches us about how the economy works. If you have questions, observations, or ideas for future episodes, email us at [e-mail].  Host: Derek Thompson Guest: Jason Furman Producer: Devon Manze Learn more about your ad choices. Visit podcastchoices.com/adchoices

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Last year, economic experts predicted a recession in 2023 with more confidence than they've predicted a recession in decades. And we've ended up with the opposite of a recession. We've ended up with what some people are calling immaculate disinflation. That is an economy where inflation is falling, but unemployment is still historically, low. Real wages are rising. Inequality is narrowing. It's not a perfect economy right now, but it's a pretty good economy. And it is nothing like the recession that we were essentially promised by experts. And you go back a bit, go to back to last fall, the fall of 2022. You do not have to look far and wide to find economic experts who are practically guaranteeing

a recession this year. Last October, a Bloomberg economic model said, at the odds of a U.S. recession this year were 100%, not 90%, not 99.99%, 100% guaranteed. In a survey by the Federal Reserve of Philadelphia, it's been conducted since the 1960s, a survey of economists who project economic growth and then they basically take an average of those projections, they model them out. The average forecast of an imminent recession hit an all-time high, a 60-year high. That is, these economic experts were more confident that we'd have a recession this year than they were confident about the stackflation crisis, the 1970s, the Volcker crisis, the early

1980s, the great recession of 2007 and 2008. And you look at the news today, we are not in a recession. The official unemployment rate is hovering around a 60-year low. The growth rate is strong, GDP growth is strong, the jobless rate for, Black Americans recently hit an all-time low. The U.S. has the fastest growth rate and the lowest annual inflation rate of any G7 country. Before we go, you know, rah, rah, American triumphalism, it's important to be clear that problems do exist. Like housing, education, health care, the price of these essentials is still way too expensive.

Wages could, of course, be growing faster. And this is important to say, last year's inflation is. is baked into today's prices. So when people say something like, oh, it's so wonderful that inflation has fallen by 70% in the last 12 months, it is really good that inflation has fallen by 70% in the last 12 months.

But that statistic, that frame belies the fact that last year's inflation happened. And it's baked into prices. So like if banana prices doubled in 2022, and now they're only growing by like 1%, Well, yes, the inflation rate of bananas has come down a lot, but it also means the price of bananas is more than double what it was two years ago. And that's going to be painful for anyone who really, really likes bananas. So no, the economy is not perfect. Yes, the inflation crisis of 2021 and 2022. And to a certain extent, the first half of 2023 is still with us. It's still living inside of the prices that we pay. But it is important, I think, to take the 30,000 foot view here and say things are super, surprisingly good,

surprisingly good compared to the nightmare, the disaster that we were promised last year. And what I want to know is, why were economic experts so catastrophically wrong about the state of and the future of the U.S. economy? What does the wrongness tell us about what we don't understand yet about economics?

What we don't understand yet about how economies grow and avoid recessions. And what can we learn from the last 24 months? Helping me in this journey of learning is one of our old guests of this show, Harvard economist Jason Furman. And we talk about the immaculate disinflation, why experts got it wrong, how the U.S. survived supply shock after supply shock,

and what happens now. I'm Derek Thompson. This is plain English. Jason Furman, welcome back to the show. Great to be back. Jason, economists are never really sure about anything. It's always, on the one hand, this and the other hand of that. But to the extent that they're ever sure about anything,

they seemed very, very certain that we would have a recession this year. We are not in a recession. We do not at the moment seem to be even close to a recession. What happened? Why did all of the experts get 2023 so wrong? Yeah. I mean, just for context, forecasters basically never forecast a recession, and then sometimes they happen. This time they forecasted a recession, and one didn't happen.

In terms of my own views, my recession probabilities were lower than a lot of other forecasters, but way higher than they would normally be. So I, too, am surprised by the economy. part of it is that there are just these massive movements. The fiscal policy we did was huge, and it has long and variable lags helping the economy, and then we did some more helpings of it with things like infrastructure, IRA, and chips. The monetary policy move was also huge,

but interestingly, and I think this might be part of the story, rates rose really, really fast, but they didn't actually rise that high. If you look at long-term interest rates, they've spent most of the last year and a half around three and a half percent. They've gotten a bit higher lately. That just isn't a high interest rate

by historical standards. And then there was just the unsnarling of supply chains. Then you throw in the Russia shock. That was a huge shock to energy prices, but it actually went away relatively quick, So another part of the forecast error was people thought, you know, oil might go to $150, $175 a barrel. Instead, it went all the way back to or even below where it was prior to COVID or anything like this. So I think there's a number of different things, but for me, the most important, our fiscal policy continued to prop the economy up.

Monetary policy just wasn't that tight, even if it got a lot tighter. and third, the oil shock went away. So we've got the fiscal policy, the monetary policy, the unsnarling of the supply chains, and then the energy shock from the Russia invasion. It reminds me that Michael Sembalist at J.P. Morgan, he called what's happening in the U.S. economy in 2023, the Rasputin effect,

Rasputin, the Russian mystic, who was shot, poisoned, attempted to be drowned and somehow survived, just an astonishing number of threats to his life before he was eventually murdered. That's the U.S. right now, just pre-Rasputin murder. It's surviving the proverbial shot and poisoning and attempted drowning. I want to go back to the first question, though,

because they were really, really smart economists, like Larry Summers and all these macroeconomists, who accurately predicted that the Biden stimulus would lead to inflation, who then went on to predict rather confidently that the only way to cure that inflation would be for the U.S. to have a recession. Again, we're not anywhere close to a recession. What does it mean for the macroeconomic field that a lot of people seem to have got it wrong? Like, how are you not surprised here? I'm a little bit surprised, but not shocked. So first of all, I've at various points put out my

sense of what underlying inflation is. The highest number I've ever had at any part, in the whole inflationary cycle was four and a half percent. So even when actual inflation was way above that, my view was a bunch of that was transitory, things like energy prices going up, but the energy prices were going down. So in some sense, all of the people who thought inflation was going to be quite stubborn agreed that some of it was transitory. The debate was over how much was transitory. Right now, my reading of the inflation data is that underlying inflation is about three and a half percent. And so it's drifted down by one percentage point, as opposed to headline inflation, which has drifted down, depending on which way you measure it,

more like four or five percentage points. So in that sense, the surprise is a little bit smaller. The second is, I think, the evidence, and this is a view, you know, Paul Krugman has the same view, is that what you'd call the Phillips curve, the relationship between labor market tightness and inflation is nonlinear, that small changes in unemployment or other measures of labor market tightness, and it's going to be important, I'm going to get into those other measures, can lead to big changes in inflation. But then as the labor market gets looser, it starts having a smaller change on inflation. And that's part of what explains inflation on the way up, and part of what explains it on the way down.

And in fact, in September of last year, I put out an analysis based on someone else's model, but my using their model. And I listed a set of unemployment rates and inflation rates. And I think I said unemployment needed to be about four to get inflation to three and a half. So we're a touch below that, but not in any dramatically, shockingly way.

Now, what we have seen, and this, I fully expected and I'm not all surprised by is some immaculate cooling of the labor market. And the form that immaculate cooling has taken is not the unemployment rate rising, but job openings falling. And for me, if I had just one variable to assess the tightness of the labor market, it would be the number of job openings for every unemployed worker. that peaked at 2.0 last year, it's fallen down to 1.6, and the entire fall has been with openings declining rather than the unemployment rate rising. And a year ago, I said I thought we'd get,

you know, two-thirds of the way back to our normal relationship for job openings on to unemployed. So I think, you know, in sort of summary and, you know, The labor market has cooled. You know, job growth has slowed. Hours have fallen. Job openings have fallen. The number of workers, you know, job openings per unemployed has fallen. So a lot of different measures of the labor market have cooled.

And inflation has also cooled, probably a little bit more than I would have thought it would cool, but not dramatically more. Now, if inflation falls to 2.5% with the unemployment rate at 3.5, then I would be very surprised, and it would cause me to revise my views. But I think, you know, I just don't think we're there yet. So we've talked about the first mystery, which is how did all these economists predict a recession in 23, while the reality is that this year could not be further from a recession? There's another mystery. There's another gap, and that is the gap between Americans' perception of this economy and the reality of this economy. So one poll in April found that at the same time the unemployment rate hit a 60-year-low,

the share of the American public that expressed negative views of this economy hit a record high. That is so interesting to me. And there's this old Jeff Bezos quotes that when there's a gap between the anecdotes and the data, you should believe the anecdotes. And I do think that it is worth taking seriously the fact that lots of Americans think this is a bad economy. But when you look at the fact that GDP is growing, unemployment is low, inflation is falling, and inequality is narrowing, it's really not a terrible economy at all. So how do you explain this gap between perception and reality? Yeah, I don't have a great explanation. There's certainly, you know, different echo chambers where people get all sorts of information.

I went on Fox News recently, and the host began with inflation is high and the unemployment rate is soaring. They had another guest who was a Republican, and he corrected the host that, no, the unemployment rate is, is near a 50-year low. But it's not just that. I mean, you see this with independence. You even see, you know, Democrats with less favorable view than they had at various times in the past. I compare the economy today to where it was three years in under Obama. And I'd much rather have this economy than the economy we had then.

We had an unemployment rate that was, I think, around 9%. We had low inflation. People had actually seen real wage gains if they had a job, but lots of people didn't have a job. I'd much, much rather have this economy. But people, you know, the level of consumer confidence, the level of, you know, views about the economy were better than now. I'm not like an expert on this question. You know, one speculation is that people did go into a very big hole in terms of their incomes being eroded by inflation up until about a year ago. And they've been digging out of the

hole, but they're still in it. Wages are about three to five percent below the trend they were on just before the pandemic. And I don't think people compute that exact statistic, but after you've gone through a huge amount, maybe one year of gains isn't enough for you and you're waiting to see more evidence that they're durable. Second hypothesis is that the people are less excited about the job gains than they normally would be. In 2011, if you got a job, you were thrilled because you were terrified that maybe you could never get another job. There have been plentiful job openings from relatively early 2021 to the present. I'm not saying anyone who wanted a job could get one, but that statement is closer to true than it's ever been in the U.S. economy.

And, you know, the recession that people went through wasn't that bad economically. In fact, incomes actually went up in 2020 and 2021 and poverty went down and all that special support is gone. So some of the credit you'd get for getting out of a recession when, you know, your income actually goes down when you come out of the recession this time rather than going up isn't there. So I think that may be another part of the explanation. So I now want to suggest that what I've actually presented as two mysteries are, in fact, the same phenomenon. And if you think that this upcoming theory is a little bit over my skis and too cheeky, please feel free to say so.

What if the reason why we avoided a recession is precisely that Americans have been so depressed about the economy. That is, the Federal Reserve is not just this, like, wizard with a joystick that controls interest rates. The Federal Reserve talks and its talking shapes expectations. Is it conceivable that the Federal Reserve essentially got us all to think that a recession was coming and that our fears of a forthcoming recession got everyone to pull back on spending just a bit, pull back on hiring just a bit, pull back on that next luxury purchase just enough that is it immaculately reduced inflation without actually causing a recession? Yeah, I think that's certainly possible.

You know, the Fed rate hikes, lots and lots of people noticed them. They noticed them in their mortgages. You were hearing about them on the news. People who didn't like them were warning that they caused a recession. People who, you know, thought you needed a recession to bring down inflation, said they'd bring one. So it was lots of different angles and lots of. the different ways. And I have no doubt that expectations play a big role. I mean, you call it vibes.

John Maynard Keynes, a hundred years ago, called it animal spirits and placed a lot of emphasis on it as well. So do I think there's like very good proof that what you just said is correct? No. Do I think it's above average speculation? Yes, absolutely. During the 2010s, The Federal Reserve was the only government agency that was trying to help the economy grow. We couldn't do anything on the fiscal side. You guys tried to pass tax cuts. You tried to pass some spending programs, but the Republicans simply weren't having it. So monetary policy was the only game in town.

And growth in the 2010s was pathetic. So the Federal Reserve, you could say, kind of didn't succeed in really pulling the economy out of this slow flation period. Now you fast forward to the 2020s. And it turns out that the Federal Reserve, while it has maybe engineered this soft landing, hasn't really had this strong effect of interest rates go up and then the economy goes into the ground. Is it possible that if you put these two stories together and realize the Federal Reserve both fail to stimulate an underinflated economy in the 2010s and failed to depress an over-stimulated

economy in the 2020s that maybe the Federal Reserve and monetary policy isn't as strong as we thought it Yeah, I think there's really something to that. And there's actually economic research that finds that the economy is less sensitive to interest rates than it used to be. When interest rates go up, it, for example, affects the manufacturing sector, which relies more on borrowing money to buy equipment than it does the service sector, which has a little bit more just an ongoing flow of costs that it doesn't borrow money to cover. As the manufacturing sector has shrunk in the economy, that's one channel by which, you know, interest rates just aren't going to matter as much as they used to. More, you know, and there's sort of a number of other things like

that. So I think that's a thing that you're starting to hear a little bit of debate within some of the federal reserves of maybe we have less power. Now, what does that mean? One version is if fiscal policy doesn't get its act together, that means we're going to be in a world where you go into recession and they cut rates to zero, and they do a whole lot of quantitative easing, which is way below what they used to do in recessions. And then you get into an inflationary period, and they have to raise rates really fast and really high, maybe even higher than they have so far. And that's a world of sort of a lot of financial market volatility as well. To the degree that thesis is true, you know, the good thing to happen would be if fiscal policy were lending a hand. And fiscal

policy has proved itself pretty good at stimulating an economy when it's in a downturn. I agree with you. It did not do enough in the wake of the financial crisis. I think it did too much this time, but both times it was directionally correct. What fiscal policy has shown no ability to do is to help cool down a heating economy. In fact, we've seen, you know, the deficit right now is actually rising again over the last year. You've seen ways in which fiscal policy has been expansionary. And the politics say people are being hurt by inflation. You're going to go pass a tax increase on them to slow that inflation. Of course not. So there's an asymmetry that I worry about where fiscal policy sort of can help solve half this problem of less

effective interest rates can't solve the other half. It is conceivable, I suppose, putting my two theories together, the vibes theory and the interest rate sensitivity theory, as you summarized my second point. It's possible putting them together that we need a new paradigm for thinking about how exactly the Federal Reserve mostly impacts the economy. And it is at least conceivable. And this is a question. And this is a question for economic research. This is a question for some, you know, PhD student out there or some economic professor out there. It's possible that the way the Fed mostly in the 2020s, 2030s, this new paradigm, changes the economy, is more through the vector of expectations

than through sheer rise in interest rates. The actual jacking up of interest rates, while, of course, important, certainly to, especially to some sections of the economy, might actually matter less than the vibes, than the general sort of optimism to pessimism gauge that the Federal Reserve has some power over changing. I think that's an interesting idea that we typically think of the Federal Reserve as like this joystick of interest rates,

but in fact, it's the way the Federal Reserve makes people feel that might be the more significant driver of economic activity. Yeah, I think that's exactly right. just to sort of think about academic economics. You know, originally expectations were just this random thing that you didn't understand. They came from somewhere and they moved around. Then they were adaptive.

People looked back and just thought whatever happened over the last year was going to happen over the next year. That wasn't really right because people are more forward looking. You know, they're looking at the Fed raising rates and thinking, how is that going to affect the economy? So then they shifted to rational expectations. They're forward-looking and calculating everything perfectly, knowing exactly what's going to happen, at least on average, correctly. That's also not right.

And so where do you go? If people aren't just naive, backward-looking extrapolators, they're not genius forward-looking forecasters. They probably have all sorts of biases, but they do process some of the news and some of the information. And, yeah, I think cracking that nut would be really, would be really. really helpful in understanding all of this. So moving into the present, then the future, we were told by a lot of economic experts last year, the 2023 would be a recession.

It so far has not been a recession, but of course it could be. So what do you think are the biggest risks to growth in the next few quarters? Yeah. So first of all, you know, normally, if people ask me, is there going to be a recession,

I say my model is that every year there is a one in six chance of a recession. So you are rolling a dollar, If it comes up one, you have a recession, but it comes up two through six, you don't. Then you can look at economic conditions and you can make it, you know, just a little bit higher probability or a little bit lower probability, but we just can't extrapolate on that well. To give an example of that, we have now had 17 months in a row where the unemployment rate has been in a 0.3 percentage point band. It's ranged from 3.4 to 3.7. The last time we had

unemployment rate for 17 months in a row that was low and within such a narrow band was November 2007. The economy hit peak in December 2007 and went into recession right after that. The point of that anecdote, and it's just an anecdote because it's one piece of data, is not that every time you have 17 months in a row of low unemployment, you go into a recession, on the next month. I don't think this is a good recession measure or a good recession predictor, but it's just to say that you really, really never know. So all the retrospectives people are writing about the economy as if, you know, the soft landing has already happened when, first of all,

the inflation rate isn't actually down to where it should be. Now, maybe it will get there, and there's some signs that it'll fall further. But more importantly, just a recession can just come out of nowhere. And by the way, that recession, it wasn't financial crisis recession when it started. The financial, you know, Bear Stearns, which was the first ratchet in a real way in the financial crisis in the United States, wasn't until February 2008. We were already two months into the recession by then. So, you know, so the first thing to say about recessions is they're a little bit unforecastable

and a little bit come from nowhere. I had been pretty disciplined in articulating that view for a very long time. I abandoned that view to some degree last year, and I regret it in retrospect, and sort of want to go back to that view. But you did ask what the risks are, and you should always be looking out for what the risks are. One is there is a possibility that the lagged effects of monetary policy will catch up with us. I happen to think most of the effects of monetary policy we've seen, but one channel is as businesses need to refinance their loans, they're refinancing at much higher interest rates, and in some cases won't even be able to refinance. And so there'll be sort of a cash hit over and over and over again on a lot of businesses, especially in things like commercial real estate. A second related one is that lending terms are quite, um, are quite high. Third is we have recently seen another round of effectively financial condition tightening

as mortgage rates have risen again, which could depress home building. The 10-year treasury has risen. The interest rate has risen about 70 basis points, 7 tenths of a percentage point in the last couple months. And so there's been some financial tightening. I think those are the things that worry me the most. And I guess the last thing that worries me is that part of the non-recession last year was the extraordinary American consumer.

And they're still spending more than I would have expected, given their incomes. And so I think at some point that consumption growth needs to slow. Your best guess is that it's sort of a gradual easing, but there could be. a sharper reduction in consumer spending growth. I would add to all of that, that as you said, part of the non-recession last year was the extraordinary growth of the American consumer. It was also the decline in oil and gas prices. Energy disinflated, and that really helped the U.S. economy because there's just nothing

worse than the cost of energy, the input into everything going up and up and up every single month. That's to a certain extent an international story over which the United States has only, you know, only a little bit of control. And I was just thinking as you were talking that one negative aspect of the Rasputin explanation for the U.S. economy is that

the U.S. is extraordinarily sensitive, if not to necessarily the Federal Reserve's interest rates, to the shooting and poisoning of geopolitics and world events. And we can't predict when the next domino is going to fall when it comes to oil supply or global wars.

You know, maybe there'll be a positive shock where China, as I've recently seen, is trying to negotiate potentially a peace between Russia and Ukraine, that could be very positive. We could also see some kind of negative shock somewhere, whether it's a climate change refugee crisis or some other invasion of an energy-sensitive country. So that's the other thing that I guess I worry about is that if the parsimonyous explanation of what's happened in the last 18 months is that the U.S. suffered one supply shock after another, inflation went up, and then over time the supply shocks resolved themselves, and so inflation came down as the American consumer continued to spend its way through the bad

times, well, maybe we're just in an interregnum of a low shock period. And in the next few years, we're just going to see a lot more shocks again, in which case the U.S. is going to have to survive a lot more proverbial killings and drowning. So that's one of the things that I'm looking at. But the hard thing there is it's just as hard as it is to predict general macroeconomic growth the next few years, it's very, very hard to predict where the next geopolitical crisis is going to come from. Yeah. So, yeah, I mean, sometimes geopolitics should always be on your list. You know, could there be, you know, some, you know, military thing between Israel and Iran that drives oil prices up? I'm not predicting that. I'm not an expert on that. I'm just saying there's always stuff that happens.

And, you know, I do think for the, I think part of why I think some of the celebrations of inflation are premature, so that energy prices have fallen about 15% in the last year. We're in a favorable supply shock. Inflation looks temporarily better than it is, and some of that probably shows up in core inflation, even when you strip out the energy just because of its indirect effects. For recession and GDP, you're right to worry about oil prices, but we should be much, much less worried about them than we used to be for two reasons. One is the economy just uses less oil per unit of GDP than it used to or more energy efficient. And more importantly,

we produce a lot of oil. So when oil prices go up, it helps one part of the economy, which is oil producers. It hurts another part of the economy, which is consumers. The net effect of that is probably a negative, but there's some hedging. And by the way, we've been talking about the U.S. economy and the recession that didn't happen, in Europe, which does not have that hedging with respect to oil, and which also had much more severe natural gas price problem as a result of the Russian invasion, the euro areas had two quarters in a row of negative growth. And Germany, which is very dependent on exports and energy inputs and was very dependent on Russian energy, its growth rate has been sort of minus two or minus three percent.

for two quarters in a row. So the people predicting a recession in the euro area, they got that right. Part of why we avoided it was the energy shock wasn't as bad here. And in some cases, like natural gas, basically barely happened here. Yeah.

That's maybe the last thing that I'm just thinking about in terms of global trade. If Europe enters a recession, China's economy doesn't seem like it's growing maybe at all, maybe in the single, low single digits, if you do have some kind of gradual deterioration in global trade at the same time that the American consumer just begins to run out of saved funds,

it's possible that some combination there could sort of pull overall real growth down and make this more sensitive to supply shocks. But it's, look, economic prediction, as I said at the top of the show, as I said in the open, is basically something close to astrology. So I won't try to make any hard predictions here. Jason Furman, thank you very much. I really appreciate it. Great being here.

Plain English was hosted and reported by me, Derek Thompson, and produced by Devin Manzi. We'll see you back here every Tuesday for a brand new episode. Have a great week.