The recession America was waiting for never came.
Many economists spent early 2023 predicting a painful recession, a view so widely held that some commentators began to take it for granted. Inflation had soared to its highest level in decades, and a number of forecasters believed it would take falling demand and a prolonged jump in unemployment to combat it.
Instead, the economy grew 3.1 percent last year, down from less than 1 percent in 2022 and faster than the five-year average before the pandemic. Inflation has fallen significantly. Unemployment remains at historic lows and consumers continue to spend even with Federal Reserve interest rates at a 22-year high.
The gap between doomsday predictions and boom reality is forcing a reckoning on Wall Street and academia. Why did economists get it so wrong, and what can policymakers learn from these mistakes as they try to predict what might come next?
It is too early to draw firm conclusions. The economy could still slow as two years of Fed rate hikes begin to add up. But what is clear is that the old models of how growth and inflation relate did not serve as accurate guides. Bad luck drove more of the initial burst of inflation than some economists realised. Good luck helped lower it again, and other surprises have happened along the way.
“We didn’t understand the macro economy perfectly before, and this was a pretty unique moment,” said Jason Furman, a Harvard economist and former Obama administration economic official who believed that reducing inflation would require more unemployment. “Economists can learn a huge, healthy dose of humility.”
Economists, of course, have a long history of getting their forecasts wrong. Few saw the global financial crisis coming earlier this century, even as the subprime mortgage meltdown that sparked it had begun.
However, recent failures have been particularly large. First, many economists dismissed the possibility of runaway inflation. When prices took off, Economists at the Fed and professional forecasters widely expected at least a brief period of contraction and rising unemployment. Neither has materialized, at least so far.
“It’s always been difficult to predict what an economy emerging from a largely unprecedented pandemic would look like,” said Matthew Luzzetti, chief economist at Deutsche Bank, whose team’s recession forecast last year turned out to be too pessimistic.
Not all economists expected a recession last year. Some correctly expected inflation to ease as the disruptions of the pandemic eased. But even most of them were surprised by how little damage the Fed’s rate hike campaign appears to have done.
“The unemployment rate hasn’t even gone up since the Fed started tightening,” said Alan S. Blinder, a Princeton economist who served as the Fed’s vice chairman during the last successful soft landing and was a prominent voice arguing that it was likely another . “I don’t know how many people expected this. I know I didn’t.”
The streak of forecast errors began in early 2021.
At the time, a handful of prominent economists, including Harvard’s Lawrence H. Summers, a former Treasury secretary, began warning that America could experience a surge in inflation as the newly elected Biden administration enacted a large stimulus package — including one-time checks and government and local aid — beyond the previous Trump administration’s coronavirus relief. They worried that the money would fuel so much demand that it would push prices up.
Many government officials and economists strongly doubted that inflation would soar, but the price has arrived. Some of it was about demand and some of it was due to bad luck and pandemic disruptions.
Stimulus money and lifestyle changes linked to the pandemic helped boost purchases of goods at a time when the supply chains set up to deliver those goods were under pressure. Cruise lines were not prepared to handle the deluge of demand for sofas and gym equipment. At the same time, manufacturers faced rolling shutdowns amid virus outbreaks.
Russia’s invasion of Ukraine in 2022 further fueled the rise in prices by disrupting global food and fuel supplies.
By that summer, America’s Consumer Price Index had peaked at an annual increase of 9.1%, and the Fed had begun to react in a way that led economists to believe a recession was imminent.
Fed policymakers in March 2022 began what quickly became a rapid series of rate hikes. The goal was to make it much more expensive to buy a home or a car or to expand a business, which in turn would slow the economy, weigh on consumer demand, and force companies to stop raising prices so much.
Such dramatic interest rate adjustments aimed at reducing inflation have typically precipitated recessions, so forecasters began predicting a recession.
“History has shown that these two things together have usually resulted in a recession,” said Beth Ann Bovino, chief economist at US Bank, referring to the combination of high inflation and interest rate hikes.
But the economy — though a challenging one for some families, between high prices and expensive mortgages — never fell off that cliff. Hiring gradually slowed. Consumer spending fell, but fits and starts and never dramatically. Even the interest rate-sensitive housing market consolidated without parking.
Strong government support helps explain some of the resilience. Households were flush with savings accumulated during the pandemic, and states and local governments were slowly spending their own government pandemic money.
At the same time, a strong labor market has helped lift wages, allowing many households to weather price increases without having to cut back much. Years of ultra-low interest rates also gave households and businesses the opportunity to refinance their debt, making them less susceptible to the Fed’s campaign.
And part of the staying power is because by cooling inflation, Fed officials could back off before they crushed the economy. They halted rate hikes after July 2023, leaving them in a range of 5.25 to 5.5 percent.
This raises a question: Why did inflation fall even after the Fed stopped easing growth?
Many economists had previously thought that a sharper slowdown was likely to be needed to fully eliminate runaway inflation. Mr. Summers, for example, predicted that it would take years of unemployment above 5 percent to wrestle price increases back under control.
“I was of the view that the soft landings” were “the triumph of hope over experience,” Mr. Summers said. “This looks like a case where hope has triumphed over experience.”
He pointed to several factors behind the surprise: among them, supply problems have eased more than he expected.
Much of the deflation came from a reversal of previous bad luck. Natural gas prices fell in 2023, and those lower prices trickled down to other industries. Healing supply chains have allowed good prices to stop rising so quickly and, in some cases, fall.
And some economic cooling took place. Although unemployment has remained fairly steady, the labor market has rebalanced in other ways: There were about two jobs for every available worker in 2022. That’s down to 1.4 now, and wage growth has slowed as employers compete less fiercely for to hire.
But this labor market adjustment has been softer than many expected. Prominent economists doubted that it would be possible to reduce conditions by cutting jobs without also causing unemployment to rise.
“I would think it’s an iron law that deflation is painful,” said Laurence M. Ball, a Johns Hopkins economist who authored a major 2022 paper that argued that reducing inflation would likely require an increase in unemployment. “The general lesson, which we never seem to have fully learned, is that it’s very difficult to predict things and we shouldn’t be too sure, and especially when there’s a very strange, historic event like Covid.”
Now, the question is what does this mean for the coming months. Could economists be caught off guard again? They expect contained inflation, continued growth and several Fed rate cuts this year.
“We have landed softly. we just have to get to the gate,” Mr. Furman said.
Fed officials could offer insight into their own thinking at their meeting next week, which ends on January 31. Investors expect policymakers to keep interest rates steady, but will watch a news conference with Jerome H. Powell, the Fed chairman, for any hint going forward.
