Inflation has receded from its peak much sooner and more rapidly than many had expected, even if it has been and may continue to be bumpy ride. The Federal Reserve (Fed) has raised rates aggressively and yet unemployment has declined to historically low levels. The picture is complex, and traditional economic thinking is not at all suited either to analyzing an economic shock such as the pandemic or the path and nature of the subsequent rebound. To make some sense of all this, we prefer to think of the economy as if it had a serious health scare. After treatment, the patient is well on the way to full recovery, yet still has some long-term health challenges to work through partly due to the side effects from medications involved. Analytically, our preference is to incorporate some of the tools of physics and complex systems analysis to help provide some perspective and bridge gaps not covered in traditional economic theory.
Figure 1: U.S. Inflation
Figure 2: U.S. Unemployment Rate
I. An Economic Health Scare: From Onset to Recovery
First, there was the health scare, an initial life-threatening illness (i.e., 22 million jobs lost in the U.S. in the spring of 2020) requiring care at the hospital amid the partial shutdown of the service economy – essentially a cascading network system collapse, in physics terminology.
Second, the U.S. economy was then given a super-dose of fiscal policy stimulus to allow consumers to keep spending even while not working. The Fed bought the equivalent of the federal debt associated with the fiscal stimulus to prevent any rise in bond yields, masking the potentially significant effects on public and private sector borrowing costs from the fiscal medication.
Figure 3: Fiscal Stimulus
Figure 4: Fed Asset Purchases
Third, the patient was released from the hospital and appeared to recover quickly. Real GDP reached its pre-pandemic peak by Q2/2021, and while the quarterly numbers are volatile, the economy continues to grow modestly. Twenty-two million jobs were lost in the spring of 2020, and by the summer of 2022, over 22 million jobs had been recovered, albeit not all the same ones as those lost.
Figure 5: U.S. Real GDP
Figure 6: U.S. Jobs Recovery
Fourth, as is common with patients given high doses of prescription medicines, new symptoms appeared from time to time despite the apparent recovery. Of these, the surge in inflation was most concerning. The causes of the inflation surge were interlinked and complex.
To cushion the loss of 22 million jobs, the U.S. federal government had provided massive stimulus to allow spending to continue despite the high level of unemployment and inability of the real economy to produce goods and services output (e.g., real GDP) at previous levels. At the same time, the pandemic led to a partial shutdown of key components of the service sector of the economy, namely hospitality and travel, which resulted in a shift in spending away from services and toward goods, which triggered supply chain disruptions in the goods sector. As already noted, to prevent any interest rate impact on the economy from the massive fiscal stimulus, the Fed held short-term rates near zero and expanded its balance sheet by almost $5 trillion mostly through purchases of U.S. Treasuries and Mortgage-Backed Securities. With strong personal consumption demand from the fiscal medicine, reduced real GDP from the pandemic onset, and no market response in interest rates due to the complementary and accommodative actions of the central bank, inflation surged – with a lag.
Fifth, with the new symptom of surging inflation, new medicine was administered, with the Fed raising interest rates and allowing its balance sheet to shrink. Traditional economic analysis involves a belief in a rates-jobs-inflation trade-off, so that it was thought that rising rates would help to subdue inflation by raising the unemployment rate and decreasing personal consumption demand. The real story evolves in a much more complicated manner than traditional economic theory might suggest because of the nature of the rebound from the pandemic and the interactions with the treatments occurred in very uneven ways and with significant lags. Essentially, our analysis takes inspiration from the physics of a sequence of critical phase transitions from a pre-pandemic economy in a steady-state equilibrium, to a cascading network collapse caused by the pandemic, to a rebound phase overlaid with major changes in policy. This takes us to examining the uneven nature of the pandemic rebound to better understand the side-effects.
Figure 7: U.S. Federal Funds Rate
Figure 8: U.S. Mortgage Rates
II. Appreciating the Nature of an Uneven Rebound in a Complex System
A. Three key ideas from physics and the science of complex systems
- Phase Transitions. The pattern of economic events we have observed is similar to a sequence of critical phase transitions from a pre-pandemic economy in a steady-state equilibrium, to a cascading network collapse caused by the pandemic, to a rebound phase overlaid with major changes in policy which themselves involve lagged effects. In phase transitions, uncertainty and volatility is concentrated on interactions that occur at the boundary of the two phases. Think of water being boiled and going from a liquid state to a gaseous state. We understand each state or phase, liquid and gas, very well. All the chaotic bubbles on the surface as the water boils and turns into a gas represent the uncertainty and volatility associated with the phase transition. Traditional economic comparative equilibrium analysis can do a respectful job of describing the different states of the economy yet tell us very little about how the economy dynamic moves from one phase to another.
- Complex Systems. Nature is an example of a complex system. Large systems tend to evolve into a self-organized state that may appear stable for some length of time. A given disturbance, though, will set in motion a sequence of feedback effects, that can lead to abrupt changes, eventually dynamically evolving into a new self-organized state. The existence of dynamic and complex feedback effects triggered by a given disturbance creates the serious challenges in understanding the nature of phase transitions effectively requiring a multi-scenario, probabilistic approach.
- Arrow of Time. The concept of the arrow of time is that events proceed sequentially and often are not reversable. That is, a given disturbance may set in motion dynamically evolving feedback effects that guarantee than one cannot go back to the previous phase – one can only go forward. Many economic models are deterministic and can be run forwards and backwards. Raise interest rates, unemployment rises, demand falls, inflation recedes. Lower interest rates, unemployment falls, demand rises, inflation ensues. Models that can seamlessly be run in reverse are totally unsuited for analyzing an economy responding to a disturbance from which there is no turning back the clock and one in which major feedback effects have been set in motion. Phillips curve and associated rates-jobs-inflation trade-off models are an example of reversible models not suited for the current situation of phase transitions in a complex system.
B. Key Questions regarding the Current Economic Situation
This takes us to examining the uneven nature of the pandemic rebound to better understand the side-effects. As we attempt to analyze a complex economy responding to a major disturbance, we will try to integrate our insights from physics and complex systems into our analysis where appropriate. Specifically, we want to focus on answering three key questions about the U.S. economy as it continues its recovery from the pandemic of 2020.
- Why is inflation receding?
- How does the uneven jobs recovery complicate the analysis?
- How important is the starting point for the Fed’s rate hikes?
1. Causes of the inflation surge are all in reverse
- Pandemic emergency fiscal stimulus. Both the Trump and Biden Administrations provided trillions of dollars of emergency fiscal spending during 2020 and early 2021 to offset the worst of the pandemic’s impact on job losses. Much of the emergency government spending was made in the form of direct transfer payments to individuals, of which a considerable amount was spent within months of being received. Indeed, one of the main differences in the fiscal response to the Great Recession in 2008-2009 and the Pandemic in 2020 was the massive fiscal response to assist individuals to keep spending even if they had lost their job. The result was that personal consumption expenditures rapidly regained the pre-pandemic peak, while after the Great Recession, there was no quick recovery at all in personal consumption, which makes up roughly two-thirds of the U.S. economy. The point we want to make here, though, is that the emergency fiscal spending has run its course and is not being renewed. Indeed, the U.S. government federal budget deficit, which hit $2.4 trillion in fiscal year 2021, declined sharply in 2022 and is on track to shrink further in 2023. The $5 trillion of pandemic related Federal spending appears to have been a major driver of the surge in inflation in 2021 and 2022. However, Federal spending has receded from a peak of 35% to 24% of GDP and appears to be less of an inflationary force going forward despite a significant increase in post-pandemic infrastructure investment.
- Pandemic shift in consumption patterns. The pandemic dramatically shifted consumption patterns with the partial shutdown of the U.S. economy. The relative share of goods consumption moved upward at the expense of services, with the limits on travel, tourism, dining, etc. For example, in the 12 months from July 2020 through June 2021, durable goods spending was 25% higher than in calendar year 2019, and non-durable good spending was up 9%, compared to modest declines in services spending. Not surprisingly, the initial upticks in inflation were most severely felt in the durable goods category, followed by non-durable goods. In the pandemic rebound with the opening up of the economy and a return to dining out, travel, etc., the pandemic-induced boom in spending on goods had run its course. Consumption demand is shifting back to services reversing this source of excess demand for goods.
- Supply chain disruptions. The global goods producing engine was not remotely ready for the surge in the pandemic-induced demand for goods, especially durable goods, such as automobiles. At the same time, in the early phases of the pandemic, COVID-19 was disrupting both production and transportation of goods. That is, the goods markets was hit simultaneously both by demand and supply shocks. Computer chip shortages hit new car production especially hard, leading to a major surge in the prices of used cars. On the transportation side, many of the goods in high demand were produced in China, and shipping costs from Shanghai to Los Angeles soared. While not all the supply chain disruptions have been fully resolved, there is no question that significant progress has been made. Supply chain disruptions are no longer pushing prices higher. And, in many cases are allowing for a decline in prices from their disrupted levels.
- Central bank asset purchases. Previous rounds of quantitative easing from 2010 to 2014, after the U.S. economy was growing again, had no apparent effect on consumer prices, GDP growth or unemployment but did, likely, play a role in inflating asset prices. The role of central bank asset purchases in feeding consumer price inflation during the pandemic is going to be debated for a long time to come. What happened during the pandemic, however, can be interpreted as an experiment in Modern Monetary Theory (MMT). When the government embarks on a major new spending program, it has the choice of financing the new spending by raising taxes, selling debt to the public, or selling debt to the central bank. The last is what goes by MMT, and this is what happened in 2020 and 2021 in the U.S. The trillions of dollars of new spending by the federal government were financed by debt largely bought by the Fed, limiting the amount of new borrowing required from the public sector.
A key point to appreciate when government spending is massively increased and associated with equally massive debt purchases by the central bank is that the price-discovery process is prevented from working. The presumption is that without central bank debt purchases, and without any tax increases, the additional supply of government debt sold to the public would have pushed bond yields higher, perhaps significantly higher. Higher bond yields would have meant higher mortgage rates, and the boom in housing prices that occurred in 2021 might never have happened, impacting durable goods demand associated with house purchases. The Fed is now shrinking its balance sheet, which as a source of potential future inflation is no longer in play.
- Interest rate policy (and lags in monetary policy). Our last observation is that the era of near-zero short-term interest rates has been decisively ended by the Fed. To the extent that an accommodative interest rate policy was a driver of future inflation, that driver has being withdrawn.
The essential argument here is that the various causes that came together to create the inflation surge in 2021-22 have all been reversed. Unlike the inflationary 1970s, when Fed Chair Arthur Burns kept the monetary policy accommodative for much too long and in the words of many pundits “was behind the inflation curve”, this time the Fed has been faster to tighten policy.
2. Jobs recovery has been exceptionally uneven
Parts of the U.S. economy actually grew in the first stages of the pandemic rebound, including social media, technology and tech-heavy Silicon Valley, as well as housing and Wall Street. These sectors hired at a rapid pace and added even more jobs than had been lost. At the same time, the hospitality sector was hit the hardest by the partial service sector shutdown and has struggled to recover. That is, 22 million jobs were lost, and more than 22 million jobs have been recovered; but they were not all the same jobs.
In the later stages of the pandemic rebound, jobs are still be added at a fast clip in the leisure, hospitality, health care, and education sectors, while job cutbacks are being announced by the sectors that grew super-fast earlier in the rebound – namely, social media, technology, and Wall Street. What is important to appreciate is that changes in the interest rate environment are a secondary influence during this period when different industries are still adjusting to a post-pandemic reality.
In addition, it is critical to appreciate the evolution of the U.S. economy over the last seven decades. Back in the 1950s, the U.S. was a manufacturing-driven economy. By the 1990s, the U.S. had transitioned to a service-driven economy. Labor unions had become less important. Wages were declining relative to profits. Companies, especially financial institutions, became increasingly sophisticated in how they managed their interest rate risk, making them and the economy less interest rate sensitive. Financial innovation in the mortgage market moved from a dependence on long-term fixed-rate mortgages in the 1950s and 1960s to a variety of choices including floating-rate mortgages and different maturities in the 1980s and beyond.
All of these changes in the structure of the U.S. economy worked to weaken the link between changes in short-term interest rates and the economy and especially labor markets. Back in the 1950s and 1960s, when the Fed raised rates, the mortgage market collapsed, hitting housing, with a knock-on impact on a wide variety of durable goods, and subsequent increases in unemployment as the economy moved into a recession. From the early 1990s onward, the changes in the economy had weakened the link among rates, inflation, and jobs. From an empirical perspective, it is a challenge to find any statistical link between the cycles of interest rates and the stability of core inflation between 1994 and 2019.
3. Zero starting point for Fed’s rate hikes
The short-term interest rate increases taken by the Fed in 2022 were often described as an “aggressive tightening” of interest rate policy. Our interpretation was decidedly different. In our interpretation, any level of short-term rates that is below a reasonable view of inflation expectations remains accommodative, just not as accommodative as zero rates. That is, the Fed in moving the effective federal funds rate, from near-zero into the 3% territory from early 2022 through the fall of 2022 was more appropriately interpreted as the Fed merely taking its foot off the accelerator, but not hitting the brakes. This first phase of interest rate increases is better described as a withdrawal of accommodation and not the commencement of an actually restrictive monetary policy. By our interpretation, the Fed only reached a restrictive stance as the federal funds rate moved into 4% territory late in 2022.
This is not to say there were not real effects from the withdrawal of rate accommodation. Bond yields rose sharply. Equities swooned as valuations had to adjust to a much higher hurdle rate and a realization that the Fed was no longer supporting equities with quantitative easing (QE) and low rates. Long-term fixed-rate mortgage rates soared and hit the housing market. Please note that bonds, equities, and housing are assets, and their prices play no direct role in the calculation of consumer price inflation. We also note that consumption growth is mostly dependent on jobs, not asset prices or rates. If the economy is not losing jobs, personal consumption, which represents about two thirds of GDP, can continue to grow even as rates rise and asset prices slump.
III. Bottom Line
One of the more interesting conundrums as we start the year 2023 is the dichotomy between the Fed’s guidance on rates policy and market expectations. The Fed could not have been clearer and more consistent (at least since the November 2, 2022, post-FOMC press conference) that once the rate hikes are paused at a sufficiently restrictive level, they will be held there for a very long time, even if the unemployment rate rises, as the Fed expects it will. By contrast, federal funds futures see a peak rate during the second quarter of 2023, with the first rate cut late in 2023, and rates moving down to the 3%-3.5% territory by end-2024. The thinking behind the market consensus in the federal funds futures market is either that inflation will recede faster than the Fed expects or a recession might develop with more serious unemployment that causes the Fed to change its view on how fast inflation will recede and shift to a more accommodative policy to cushion the higher level of unemployment than it expected.
Figure 9: Effective Federal Funds Rate
Figure 10: Fed Funds Futures
Our base case is more nuanced: headline inflation may drop below core inflation later in 2023. Core inflation will remain sticky and well above the Fed’s 2% target, while the economy and job gains slow down an actual recession may be avoided. On the labor market front, the resolution of post-pandemic asymmetries in how jobs were lost and recovered may take many more months to resolve, suggesting that for a little while longer job gains in the hospitality and leisure sectors may offset any net job losses in technology and finance should they occur.
Over a longer period of time, we also recognize that the labor force is not growing, that the pace of young workers entering the job market is stagnant, and that baby boomers are retiring in large numbers. That is, demographic patterns may work to prevent the unemployment rate from rising even with slower or very little net job growth due to the labor force being stagnant. These same demographic patterns may keep upward pressure on labor costs, but we would view this more as a relative shift of power between labor and capital (profits) and not a source of future inflation pressure. That is, the wage trend may impact equity valuations (i.e., slower profit growth with labor expenses rising) much more than inflation.
There will be bumps in our base case requiring consideration of alternative scenarios. The pace of receding inflation and the possibility of a recession might continue to be argued among market participants, especially if the Fed holds short-term rates steady at an elevated and restrictive level and the yield curve remains inverted. Inverted yield curves with short-term rates meaningfully higher than longer-term bond yields have been a reliable indicator of rising risks of a future recession some 12-18 months down the road. So, while our base case avoids a actual recession, there remains a significant probability that a recession might commence late in 2023 or in 2024. We do note that past recessions generally involved something important breaking in the financial system. In 1990-1991, it was the failure of many savings and loan institutions. In 2000-2001, it was the tech wreck on Wall Street. In 2007-2008, it was the sub-prime mortgage crisis, with the bankruptcy of Lehman Brothers and the bailouts of AIG, the banking system and the automotive sector. This time around, the financial system looks considerably better capitalized with healthy profits. Maybe the inverted yield curve will trigger something to break, but it has not happened yet.
Finally there is the debt ceiling. Debt ceiling debates are always nail-biters, going down to the last possible minute, and then sometimes being kicked down the road for a week or two with a temporary resolution. Without doubt, though, the debt ceiling is a volatility inducing event, and this current episode with extreme political polarization looks even more disruptive than the August 2011 incident when Standard & Poor’s downgraded the U.S. government debt credit rating. At that time, equities swooned, and Treasury bonds rallied in a flight to quality, despite the credit rating downgrade. It is going to be a very interesting summer of 2023 in the bond markets. While we put the probability as relatively low, a failure to raise the debt ceiling or to do in a manner that caused some harm to the U.S. economy, is on the list as a low-probability recession cause.
The post-pandemic economy, as we describe it is a complicated beast. The bottom line, though, is the inability of traditional economic models to provide much guidance for an economy going through such serious phase transitions suggests that we are in an extended period of elevated uncertainty, and that the Fed and market participants are likely to be increasingly data dependent in 2023. As the facts change, so will the Fed and markets.
Appendix: References with Notes
For the interested reader that wishes to go deeper into this type of phase transition and complex systems analysis, the following references may prove to be of value.
- Dr. John Rutledge, “Far from Equilibrium Economics, Finance & Investing”, http://drjohnrutledge.com/. Dr. Rutledge is Chief Investment Strategist and a member of the Investment Committee at Safanad, a global principal investment firm in New York, London, and Dubai. He is a Senior Research Fellow at Claremont Graduate University where he teaches and chairs dissertations in the economics and finance PhD program.
- Bluford H. Putnam, "From phase transitions to Modern Monetary Theory: A framework for analyzing the pandemic of 2020." Review of Financial Economics (RFE), Volume 39, Issue 1, January 2021, pages: 3-19. According to the publishers of the journal, Wiley, this article was one of the top downloaded articles in the 12 months after its publication in RFE.
- Per Bak, How Nature Works, Springer Science + Business Media, New York, 1996.
- Ilya Prigogine, The End of Certainty, The Free Press, New York, 1997, original version in French published by Éditions Odile Jacobs, 1996. Viscount Ilya Prigogine won the Nobel Prize for Chemistry in 1977.
- Albert Camus, Le Peste, 1947. English version, The Plague, (Translated from the French by Stuart Gilbert in 1948). Albert Camus won the Nobel Prize for Literature in 1957. This literary masterpiece is one of the best and most entertaining ways to appreciate how a pandemic changes everything.
- Erica Thompson, Escape from Model Land, Basic Books, London, 2021.
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All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.