For the second year in a row, the U.S. economy enters January under a considerable cloud of uncertainty. In January 2022 inflation was 7 percent, and the “transitory” narrative pushed by defenders of the current administration was itself proving quite transitory in the face of stubborn reality. Although the demand for workers remained strong as the economy continued to ride the wave of a V-shaped recovery that began in summer 2020, businesses were struggling with a labor supply shortage that was driven at least in part by the massive wave of deficit-financed government transfers from the American Rescue Plan Act in spring 2021 that actively pushed workers to stay on the sidelines (most predominantly by extending excessively generous unemployment benefits despite a robust job market and stripping the Child Tax Credit of work requirements).
A year later, in January 2023, a lot has changed, but some things remain the same—especially the amount of economic uncertainty on the horizon. The economy began the year with rock-bottom interest rates, but after the Federal Reserve finally came to terms with the persistence of inflation, it wisely abandoned its lax stance and proceeded to tighten the screws by raising interest rates at an extremely rapid pace—taking its benchmark Fed Funds rate from 0 percent at the beginning of the year to over 4 percent by the end. During this same period, mortgage rates jumped from historically low levels of under 3 percent to over 7 percent. As a result, existing home sales fell by 35 percent over the year, and residential investment plummeted. Meanwhile, gross domestic product shrank during the first two quarters of the year but managed to register a respectable number in the third quarter (fourth quarter data is not available yet).
The primary questions on everybody’s minds entering 2023 are these: Can the economy achieve a soft landing? And can inflation come down without the U.S. economy entering recession? Unfortunately, it is still far too early to tell. Today’s jobs report revealed that the labor market continues to hold up, with payrolls growing by 223,000 in December 2022 and the unemployment rate falling to 3.5 percent. While these data are good news, they don’t tell us much about the future, because the labor market tends to lag the rest of the economy. In other words, if the U.S. economy hits turbulence in 2023 and enters recession territory, the labor market response will likely be delayed, as has been the case historically. In the meantime, the main takeaway from the most recent jobs report is that the prospects for the Federal Reserve reversing its rate hikes are basically nil—at least until inflation drops back down to 2 percent and remains there for a while. The recent release of the Federal Reserve’s minutes from its most recent policy meetings confirms that there is no sentiment at the Fed to begin rate cuts anytime soon.
It is still possible to gather some other tea leaves from some of the recent economic data, however, to get a sense for where the economy may be headed. The downside of the latest jobs data is that there is little to no evidence that workers are being enticed from the sidelines. As shown in the chart here, the labor force participation rate—which counts people who are working and those actively looking for work—remains below 2019 levels by a full percentage point. Some of the drop is due to early retirements during COVID-19, but if one looks at the data just for prime-age workers (those between the age of 25 and 54—see the chart here), their labor force participation rate hasn’t fully recovered either. With 1.75 job openings per unemployed worker, the labor shortage has no imminent end in sight, which also complicates the inflation picture by making it more difficult for businesses to accommodate demand without raising prices.
Thankfully, the end of 2022 offered some promising signs for inflation. Most directly, the inflation data itself showed some moderation, although it continues to run hot at over 7 percent year-over-year. Also, the most recent jobs report showed that wage pressures also may be subsiding to some extent. Of course, faster wage growth in principle is a good thing for workers, but only when driven by sustainable forces. Over the past nearly two years, wage growth has run hotter than in prior years, but the increase took place amidst a backdrop of declining productivity. The result has been even faster price growth, resulting in a steep drop in purchasing power, leaving families poorer in terms of their living standards. Going forward, 2023 offers a lot of uncertainty, and data over the next few months regarding inflation and productivity will be quite revealing. One thing working in the economy’s favor is a divided Congress, which should mean a stop to the glut of inflationary government spending. The question is whether it will be too little, too late to avoid a hard landing.