So the big story in the U.S. in terms of the economy over the last 2 years has been inflation. Unfortunately, inflation is likely to be the dominant driver of our story for the next 24 months as well. The question is going to be what the Federal Reserve does in response to the inflation that we see.
Here at Barnes Analytics, we like to take the view that predicting what the Fed will or won’t do is somewhat futile. What you want to know is if we stay the course what does the world look like over the next two years. So in the analysis that follows, we make the assumption that the Federal Reserve is simply going to hold interest rates where they are at. I think that this is probably the right assumption to make after looking over the output from this model. The reason why is that it looks to be unlikely that the Fed will need to raise interest rates any further to achieve their objective of 2% inflation. That being said, my model is indicating that the Fed will likely need to reduce interest rates at some point in the next 24 months so that they don’t overshoot their 2% target!
So we’ll start by assuming that the Fed will keep the federal funds rate at 5.3% for the next 24 months. The question is what will that do to inflation? Before we answer that question I think it is instructive to think about what drives inflation. Simply put, inflation is what happens when the government prints too much money too fast, so prices start to rise such that the demand for money and the supply of money reach a stable equilibrium. So before, we dive into the model, let’s take a look at what the U.S. money supply looks like since we greatly expanded it during the pandemic. In the following chart, we have taken the natural log of the money supply. Note the money supply is growing at a fairly constant rate up until the stimulus from the pandemic. Now we have too much money in comparison to the normal trend.
Until the gap between the money supply and this trend line closes, I anticipate that we will have above average inflation. The fed raising interest rates has caused the money supply to decrease, but not at the same rate at which we created the money. In effect, this is good. It signals that the Fed has not been overly aggressive in combating inflation. In effect, they are still shooting for a soft-landing. The real question in my mind is whether or not the Fed will hold interest rates too high for too long. If they do, we will fall below that trend line and a new danger will emerge, deflation. There is no sign yet that this will be a persistent problem, and it means that the Fed may indeed engineer a soft touchdown.
On that note, I expect that the Fed will prefer to have slightly above their target range of inflation as they attempt to approach trend asymptotically from above. Therefore, I foresee a loosening of interest rates towards the end of 2024, but the declines in the federal funds rate will be gentler than the recent rise. Indeed, I think that barring a significant recession, the Fed will be inclined to keep interest rates higher than they have for the past 15 years.
Now, in the last paragraph, I brought up the specter of a recession. So I think that it is time to introduce my base model of the economy. My model requires a selection of the path of the federal funds rate into the future. We have two options, one is to try and guess what the Fed will do with interest rates, and when they will do it. I don’t like to play that game. I have my guess that for the next 4 quarters we will likely see a fairly consistent 5.25 to 5.50% federal funds rate, which we will see begin to taper in early 2025, as the Fed brings the money supply back in line with the previous trend. However, for my model I make a more simple assumption about what the Fed will do to the federal funds rate. I simply assume the Fed will hold rates constant for the next 24 months.
Let me motivate this assumption briefly. First, this gives us a baseline of what to expect with the economy. We will be able to understand where the risks currently lie. Second, given that I already expect the Fed to become more dovish over the next 12 months as the money supply, and thus inflation, comes back into line with historical trends, the no change scenario that I am proposing gives you something of a worst-case scenario to ponder.
The model of choice takes into account complicated relationships both in the long and short-run between many economic variables. Some variables of note, GDP, Unemployment, Inflation, the Money Supply, etc. What we find is that on the national-level, is that the federal funds rate is likely going to drive down inflation, but it will anchor GDP growing at a reasonable rate (real-GDP will likely dip slightly from current levels).
My model is predicting a base case of decent, if somewhat anemic growth. The confidence intervals around the forecast are quite wide mainly because of the large exogenous, and fairly recent, shock of the pandemic, reflecting the large unknowns and risks still inherent in this economy.
Probably, of more interest to the reader is the bottom of the confidence interval. What does that tell us about the risks of recession? Well, this model is giving us a 38.97% chance of a recession over the next 24 months. That is what I will call a non-trivial chance of recession. The fact of the matter is that we have never had to successfully reboot the American economy before after so much stimulus, and such a large negative shock! Recessions are a very real possibility.
In the case that we do have a recession, how long is it likely to last. It won’t be a particularly deep recession. The maximal loss to GDP that I am calculating from this model is about 2.8%, however, it could persist for some time. Like about 24 months. The model does not envision large upticks in the unemployment rate, though it does envision somewhat of an increase to the low 4% range. Based on this information, in the event of a recession, it will be more like a malaise that settles in over the economy, where things just aren’t growing. In fact, the effect will probably look something like stagflation of the late 70s and early 80s. However, inflation will continue ticking downwards over that period.
Overall, a recession probably won’t be too bad. Incomes won’t grow very much, leading to a reduction in the inflation rate, and relieving pressure on the Fed in regards to worrying about a wage-price spiral.
There is little cause for concern. With an almost 40% chance of a very mild recession on the horizon, it is very easy to look on the bright side, there is a 60% chance the Fed will achieve what it set out to do, engineer a soft-touchdown on its inflation target. Furthermore, my model is assuming that the Fed will sit on their hands instead of adjusting policy. This is the worst case scenario with recession fears coming down as time goes on, and as the Fed reacts favorably. I would expect the federal funds rate will come down in response to the money supply approaching trend, and the fears of recession collapsing as we glide in.
That being said, there is still room for a lot of suffering, and really it depends on if the middle class consumer in America can continue to absorb shocks and hold the line. There are significant geopolitical risks, such as war, supply chain disruptions, political rhetoric and scare tactics during an election cycle, and risks from global competitors to the U.S. going into recession and upsetting the delicate balance being forged by the Fed. So there is plenty of room for a recession, it just likely, won’t cause much of an impact if we see it. The fear of recession and its impacts is probably a greater driver of a recession than the fundamentals of the U.S. economy.