Throw Out the Recession Forecasts; The U.S. Economy Is Reaccelerating

Benign summer inflation figures suggest a pause in Fed tightening.

BY LARRY KANTOR & BOB DIAMOND

The COVID business cycle is largely behind us. It began with a crash in the economy and financial markets. Then came a spectacular rebound due to unprecedented government stimulus, as well as pent-up demand as people resumed going out and about. Real GDP fell at an annual rate of 30% in the second quarter of 2020, rebounded about as much in the following quarter, and then grew at a robust pace of close to 6% in 2021. This was followed by a year of sluggish growth as the Federal Reserve reversed course and raised interest rates at the fastest pace in 40 years— just as fiscal policy tightened passively due to the expiration of most of the COVID stimulus programs. The economy managed to avoid recession, but growth slowed to a pace of only 1% last year.

The question now is: Where do we go from here? GDP growth in the first half of this year averaged 2.2%, and there are a number of reasons to believe that this is the beginning of a pickup in the pace of economic activity.

THE ECONOMY IS LIKELY TO SHOW CONTINUED STRENGTH IN THE COMING MONTHS

Housing and manufacturing—the interest-rate-sensitive, cyclical sectors that were crushed last year and largely responsible for the economic slowdown—have bottomed and are turning up. Housing has rebounded already: All the activity data—from sales to construction starts to permits—have moved up since the start of the year.

Manufacturing—and the goods economy at large—remains in the doldrums but is likely to improve over the next several months. While production indicators have stabilized at low levels, the demand for goods is improving, and inventories have already adjusted. Car sales, for example, are up 18% so far this year.

Meanwhile, the service sector—which accounts for around three-quarters of the U.S. economy—remains strong and still has legs, as people are continuing to make up for lost time experienced during the pandemic. Household income is being bolstered by continued job growth and the fact that wages have recently begun to grow faster than inflation, which in turn is supporting consumer spending. In addition, households have not yet exhausted the $2 trillion-plus in excess savings that were built up during the pandemic.

Finally, fiscal policy has become expansionary again. The budget deficit as a percent of GDP collapsed from 15% in the fiscal year 2020—the highest by far since WWII—to 5.5% in the fiscal year ended in September 2022, due to the expiration of the many COVID support programs. Over the past 12 months, however, the budget deficit has jumped to around 8% of GDP, which amounts to significant fiscal stimulus. (It added two-thirds of a percentage point to U.S. GDP growth over the past year.) For reference, it was 4.6% in fiscal year 2019 and has averaged 3.5% over the past 50 years.

CORE INFLATION IS LIKELY TO CONTINUE EDGING LOWER DESPITE STRONGER GROWTH

Headline inflation—which is what really matters to households—has already dropped sharply to around 3% from a year ago. It’s down from a peak of 9% for the Consumer Price Index (CPI) and 7% for the Personal Consumption Expenditures index (PCE), which is the Fed’s preferred measure. But the decline in core inflation (that is, excluding food and energy), which is what the Fed targets, stalled in the first half of this year. It has fallen much more modestly, from 6.6% year-on-year to 4.7% for the CPI and from 5.4% to 4.1% for the PCE. That said, recent figures have provided hope that core inflation has resumed its decline. Monthon-month core inflation numbers have slowed dramatically the past couple of months.

There are good reasons to believe that core inflation will continue to make progress. The PPI (prices that producers pay for their inputs)—which is a leading indicator of inflation—has been declining since November. In addition, the PPI for intermediate goods—those used