A case of optimism?

United States
A case of optimism?
Starting in early 2022, talk of recession was in the air.1 That summer, internet searches for “recession” peaked at a level that was more than 20% above the level of searches when the pandemic started in March 2020.2 Some well-known economists had argued that inflation would only drop if the unemployment rate rose substantially.3 But inflation has moderated, yet no recession has occurred. The labor market continues to grow, and the unemployment rate remains at extremely low rates.
Now, recession fears are falling. The August National Association for Business Economics Policy Survey found that two-thirds of the panelists are confident of a “soft landing.”4 The Wall Street Journal’s survey of economic forecasters found a drop in forecasters’ probability of a recession.5 It certainly looks like an outbreak of surprising optimism from dismal scientists.
A cynic might assume that optimistic economists are a sure signal of a downturn, but the optimism reflects reality. Even if monetary lags are “long and variable,” most economists would have expected a 5-percentage-point rise in the funds rate over such a short time period to have slowed the economy more than what we have seen so far. And inflation readings during the summer were low enough to suggest that despite continued issues in some sectors, overall price inflation was under control.
The economy is indeed slowing. But GDP still appears to be growing faster than its long-run potential—the growth rate that can be sustained in the long run. And job growth has slowed, but the economy continues to add jobs at rates that are much greater than the underlying growth of the labor force. GDP and employment growth will have to slow even more sooner or later to reflect longer-term trends. In our forecast, we estimate that labor force growth will fall to around 500,000 per year in the coming years. The level of job growth consistent with full employment would then be just 41,000 per month. Increased immigration and unusually high growth in labor force participation could allow faster job growth, but it would be hard to bet on either of these scenarios.
On the face of it, this would seem to call for even more Federal Reserve (Fed) tightening, as slow labor force growth keeps the job market tight. But two problems arise. First, those “long and variable lags” of monetary policy tightening suggest the possibility that a slowdown is already embedded in economic decision-making. Of course, many economists have been saying this for about a year, and they have been wrong. That’s why we are seeing the current bout of optimism. But what if the economy finally comes to the point when the impact of past monetary policy starts to show up? After all, it’s been less than two years since the Fed started raising interest rates. Second, Fed tightening has already created fragility in financial markets. The Fed doesn’t intend to create a recession by sparking a financial crisis. The higher it raises interest rates, however, the more likely such a crisis becomes.
Despite all those possible reasons for gloom, the US economy is coming into fall with continued growth, lower inflation, and the possibility that all that talk about recession was, in the end, just that—talk.