As someone who has spent over three decades flying planes as a hobby, I've picked up a couple of key principles that are just as relevant in the cockpit as they are in economic forecasting. The first is that any adjustment to the controls needs to be balanced by a corresponding change elsewhere to maintain stability. The second is to avoid overreacting to turbulence—let the plane find its balance naturally.
These same principles apply to understanding and predicting economic trends. If you make a change in one variable, you must adjust others to maintain a coherent outlook. And when faced with economic turbulence, making constant small adjustments can do more harm than good.
Recently, there’s been a wave of pessimism about the U.S. economy, leading many investors and traders to assume that we’re headed into a severe recession. This belief has fueled speculation that the Federal Reserve needs to slash interest rates immediately—potentially even resorting to emergency cuts between meetings—and that it should cut rates by at least 0.5% at multiple upcoming meetings.
But as we approach the release of the next Consumer Price Index (CPI) report on August 14, it's crucial to ask: if you've adjusted your recession forecast, shouldn’t you also reconsider your inflation expectations? Surveys of economists who dare to make predictions this early still show a consensus of a 2.9% year-over-year increase in CPI, consistent with expectations from weeks ago.
This raises a critical question: How can you maintain the same inflation outlook despite a drastic change in your economic forecast? Basic economics tells us that if you’re predicting a drop in GDP due to a recession, your inflation expectations should logically decline as well. If you’re convinced that a recession is already here, shouldn’t your CPI forecast be revised downward accordingly?
For those in financial markets who have not adjusted their inflation forecasts despite expecting a recession, the risks are skewed to the downside. You should be prepared for a potential surprise in the form of lower-than-expected inflation data in the coming days.
But what if you haven’t adjusted your recession forecast despite weak job data, a construction slump, rising unemployment claims, and softening Institute of Supply Management indices? As Federal Reserve Chairman Jerome Powell frequently emphasizes, the Fed doesn’t alter its monetary policy based on a single data point—and neither should you.
Looking at the broader data, the July jobs report showed 114,000 new jobs with unemployment at 4.3%. While this indicates a slowdown in job creation, the economy is still adding jobs, not shedding them as it would in a true recession. Unemployment claims, while gradually rising, are still at levels not seen since the late 1960s. In a real recession, claims would spike dramatically.
There is, of course, evidence of weakening retail sales, with the latest Fed Beige Book highlighting that consumers are becoming more price-sensitive, opting for discounts, and cutting back on non-essential purchases. Additionally, the consumer credit data released on August 7 shows that households are paying down credit card debt, suggesting reduced consumption.
However, it’s important to remember that the economy grew robustly through the second quarter of this year. The starting point for any slowdown is relatively high, providing some cushion to slow down growth without triggering a full-blown recession. The Atlanta Fed’s GDPNow model, for instance, is currently predicting 2.9% GDP growth for the third quarter—hardly a sign of recession.
Returning to my flying analogy, remember the second rule: avoid making hasty adjustments when the ride gets bumpy. The economy is slowing down, partially due to higher interest rates and excessive borrowing, but this deceleration will have its fluctuations. It’s wiser to stay focused on the longer-term outlook rather than reacting to every minor blip.
In conclusion, the fundamental economic and inflation outlooks have not significantly changed, despite recent softer economic reports. This economic journey is likely to lead to more moderate growth and stable prices. So, before pushing for rapid rate cuts, it might be wise to slow down and let the economy find its own balance.
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