2023 Economic Outlook: A Grim Reality Check

In early 2021, I was in the school of thought that was sure inflation must follow the massive monetary and fiscal stimulus provided by various branches of the U.S. government. Somehow, this was a controversial idea at the time. Once inflation did indeed accelerate, the original inflation skeptics began to blame various supply shocks, disregarding significantly elevated aggregate demand (a view I explain in depth here). But, soon enough even Federal Reserve Chairman Powell began to ditch the notion of inflation being driven by supply shocks, and acknowledge that excessive stimulus does come with consequences. 

Fast forward to today, many economists have begun throwing around the notion of a soft-landing from the Fed’s rapid tightening of monetary policy. For three straight months we’ve seen inflation reports delivering great news, in particular November and December’s disinflation being greater than predicted, leading economists to believe that inflation will subside by itself and the Fed will not have to tighten further. And without further tightening, the economy should be able to stay on its feet and not fall into its second recession in three years. 

Unfortunately, I’ve been unable to hold such optimistic views for the future of our economy. While I hope for nothing besides a soft-landing, I’m skeptical that such a result is even possible at this point. I’ll speak to what I think is to come in the coming year, and will try and address arguments held by deterrents to my view as I go. 

Let’s start with inflation, probably the most important word of 2022. I’m personally not a big fan of headline CPI, the most commonly used measure of inflation. Most economists tend to prefer PCE, which tends to be more accurate as CPI is believed to overstate both upward and downward fluctuations. CPI still is not too bad usually, and is released much earlier in the month, so both will be used throughout this piece. Within CPI and PCE, there are various measures of inflation. Two of the more popular measures are Core CPI and Core PCE, which excludes energy and food prices, whose price fluctuations are known to be more prone to the supply side. For some reason, over the last three months when headline inflation measures have been falling, economists have stopped citing the perfectly stagnant Core CPI and PCE. Much of the fall in headline inflation is driven by fuel costs falling, which indeed is helpful to Americans, but not representative of the overall trends of inflation.

When it comes to understanding the trend of inflation, I prefer to examine Median and Trimmed CPI/PCE. Median inflation measures are quite self explanatory, taking the good/service in the middle of all inflation movements. Trimmed inflation measures exclude the top and bottom 8th percentile of goods/services that increased and decreased the most. Both these measures better show us the macroeconomic trend of inflation, and do a good job of discounting industry specific price changes. 

In the 3 months that annual headline CPI inflation has fallen by 180 basis points, median CPI inflation has fallen by just 5 basis points. Trimmed CPI inflation has fallen by a bit more, nearly 80 basis points, but still far less than its headline counterpart. While we don’t have December data for the various PCE statistics till January 27th, Trimmed PCE has fallen by 12 basis points in its last three reporting periods, compared to headline PCE’s roughly 70 basis point fall. Median PCE fell by roughly 25 basis points.

Now that’s a lot of data. Let’s make some sense of it. I’m not arguing that inflation is not falling, median and trimmed data clearly show some drop off, even if much less than headline measures indicate. Supply shocks’s real effects have clearly begun to wane, and because some portion of inflation was indeed caused by supply shocks, one should expect inflation to fall accordingly. The issue is that not all inflation was driven by supply shocks. Aggregate demand remains at sky-high levels, and some part of inflation will not resolve until demand cools off further. And unlike supply shocks, aggregate demand is a self-fulfilling prophecy which cannot and will not subside on its own. Further Federal Reserve tightening is needed to blunt aggregate demand, and truly defeat inflation. 

You may have seen many economists arguing that much of inflation is back-ended, meaning that when we view year-over-year inflation, most of the number is being driven from the first six months. And thus they cite headline CPI/PCE being much lower in the last 6 months. This is indeed true, but still does not provide the full picture. Each median and trimmed measure of inflation still shows a stagnant level of inflation when narrowing analysis to 6 month, or even monthly inflation. Much of supply side inflation is indeed back-ended, but as stated before, demand driven inflation has remained consistent throughout this cycle, and will not fall absent further tightening. 

Headline CPI inflation will fall for the next few months, which the Fed will likely interpret as inflation falling without needing to tighten further (which they’d like to avoid). But since much of inflation is demand driven, absent Fed tightening in early 2023, inflation will fall to roughly 4-5% and then plateau. This plateau will necessitate yet another Fed pivot, as aggregate demand will likely still be elevated, and the Fed will need to tighten further in mid-2023. 

I would be quite surprised if this further tightening does not bring about a recession. Seeing that the ten-year tech bubble has already begun to burst, with Alphabet (Google’s parent company), Microsoft, and Amazon firing over 40,000 employees in January alone, one must worry about what’s next. Furthermore, as Milton Friedman famously stated, monetary policy works with “long and variable lags.” This means that much of the effects from last 2022’s tightening on investments that were once profitable when interest rates were near zero are still yet to be felt. It’s hard to imagine that any further tightening wouldn’t put the nail in the coffin. I don’t believe last year’s monetary policy will have much of an effect on inflation this coming year, given how markets reacted to the Fed’s tightening, and how much inflation expectations have already fallen.

There is one scenario I foresee where the stated predictions do not come into fruition. If the Fed sees inflation plateau at 4-5%, there is a chance that they begin to prioritize the other side of their dual mandate, and maintain full employment while leaving 4-5% inflation. I do not believe that this will be the case for a few reasons. The 1970s has scarred economists enough to know not to allow inflation to persist, as it can easily ramp itself back up. Furthermore, after months of promising to bring down inflation to its 2% target, the Fed would lose considerable credibility were it to suddenly back down from its goal. And credibility among investors is something that the Fed takes very seriously. So while this is a possibility, it’s not one I see as likely to occur. 

All in all, it’s important to make sure your household has adequate savings in case of a recession later this year. The first half of 2023 will likely be marked by a bull market, being bolstered by each falling inflation report. And while I would be overjoyed to be proven wrong, I think the public should curb their enthusiasm, as the worst is yet to come. 

My apologies for such a somber piece, but I believe economics ought to be descriptive and avoid telling a rosy picture that does not allow households to meaningfully prepare for what’s to come. I can’t help but think of one of my favorite youtube videos, compiling clips of former Fed Chairman Ben Bernanke in constant denial that a housing bubble was underway in the early 2000s, until it finally bursted. If you are ever in need of a laugh, check this out.