Recession avoided, inflation down as economy defies dark expectations

After two years of relentless pressure over everything from sky-high inflation to a looming recession, the head of the Federal Reserve was asked this month what he does for fun.

“For me, a big, big party — and I mean, this is really as fun as it gets — is a really good inflation report,” Jerome H. Powell said before a crowd at Spelman College. He flashed a smile and laughed.

For an official who typically sticks to a tight script, the quip was downright jubilant. But it also reflected a subtle mood shift from the central bank — and from a leader who feels finally freed to crack a joke in the first place, however restrained.

As 2023 winds to a close, Powell and his colleagues are far from declaring victory on inflation. They routinely caution that their actions could be thwarted by any number of threats, from war in the Middle East to China’s economic slowdown. Americans are upset about high costs for rent, groceries and other basics, which aren’t going back to pre-pandemic levels. The White House, too, is quick to emphasize that much work remains.

Yet the economy is ending the year in a remarkably better position than almost anyone on Wall Street or in mainstream economics predicted, having bested just about all expectations time and again. Inflation has dropped to 3.1 percent, from a peak of 9.1. The unemployment rate is at a hot 3.7 percent, and the economy grew at a healthy clip in the most recent quarter. The Fed is probably finished hiking interest rates and is eyeing cuts next year. Financial markets are at or near all-time highs, and the S&P 500 could hit a new record this week, too.

That strength and stability — defying even many of the most optimistic predictions — represents a remarkable development after seemingly endless economic crises that started with the 2020 covid pandemic and continued through an inflation spike that the bank and the White House were slow to recognize.

The Fed and White House fought inflation on their own distinct tracks using entirely different tools. But now, the central bankers, Treasury Secretary Janet L. Yellen and President Biden’s economic brain-trust are cautiously pointing out that they have been vindicated by data and developments dismissed as virtually impossible until quite recently. This month, Biden’s typically staid treasury secretary gave an unusually direct rebuke, telling reporters that economists who predicted that lower inflation would require widespread layoffs were now “eating their words.”

Call it the most polite revenge tour Washington has ever seen.

“So many economists were saying there’s no way for inflation to get back to normal without it entailing a period of high unemployment, [or] a recession. And a year ago, I think many economists were saying a recession was inevitable,” Yellen said at a Wall Street Journal event last week. “I’ve never felt there was a solid intellectual basis for making such a prediction.”

A day later, Powell gave his own nod to the doomsayers. The Fed chair’s tone has always been more circumspect: He routinely emphasizes that the central bank can’t declare victory yet and that plenty of hazards stand in the way of getting inflation to its 2 percent target. That message has stuck even as the Fed penciled in three rate cuts next year — causing the markets to start popping the champagne.

Yet Powell, too, has held onto hope that this was possible, despite what conventional economics might teach. Since 1961, the Fed has launched 10 cycles of rate hikes to combat inflation, including this one. Recessions followed eight times.

“I have always felt since the beginning that there was a possibility, because of the unusual situation, that the economy could cool off in a way that enabled inflation to come down without the kind of large job losses that have often been associated with high inflation and tightening cycles,” Powell said last week. “So far, that’s what we’re seeing.”

There’s still plenty of debate around how the economy’s “soft landing” was achieved. Some deny that it has even occurred, or that either Powell or Yellen deserve credit. Much of the drop in inflation, for example, didn’t come from the Fed’s higher interest rates, but from supply chains clearing backlogs and energy prices cooling.

Plus, many Republicans still fault the Fed and the Biden administration for exacerbating last year’s soaring inflation — the fastest price increases in four decades — and for the monetary policy interventions that followed. Prices aren’t going up as fast anymore. But they’re still high, and high interest rate hikes have put the dream of homeownership out of reach for millions, a key GOP talking point ahead of the 2024 presidential election.

“All hard landings begin as a soft landing — never forget that. There’s been a lot of good news, and everyone should be happy about it, but I would not declare victory too soon,” said Doug Holtz-Eakin, a GOP analyst and former director of the Congressional Budget Office. He pointed out that private sector growth appeared to be slowing down in the most recent quarter, adding, “I see an economy that could easily get knocked south, and that is not going to be fun for anyone.”

‘Dark, brooding despair’

“Forecast for US Recession Within Year Hits 100% in Blow to Biden,” a Bloomberg headline flashed in fall 2022. Larry Summers, the former Democratic treasury secretary and frequent Fed critic, said unemployment would have to spike for inflation to come down. Businesses said they were girding for a downturn.

It looked like severe economic pain would be the cost for the president and central bank chair being late to react to historic inflation, and clinging for too long to an insistence that price hikes would be a temporary blip. One outside White House adviser, speaking on the condition of anonymity to reflect private conversations, described the mood in the building as one of “dark, brooding despair” as inflation peaked in summer 2022.

“It tested your resolve: We were constantly testing and resting the assumptions we were operating under, because it was such a brutal period,” said Brian Deese, who served as the director of the White House National Economic Council during Biden’s first two years in office, referring to last year’s inflation peak. “But I do think the White House deserves some credit for staying consistent, and for the president’s conviction that you could transition to strong and stable growth without a recession, even as we were being constantly questioned and doubted.”

All the while, the Fed and White House took their own key measures to rein in price hikes. The Fed started hiking interest rates in March 2022, moving at breakneck speed to get interest rates to the highest level in 22 years. It did so despite criticisms from the left that it was slamming on the brakes too hard and risking peoples’ jobs.

Powell and Biden officials consistently maintained that they could get inflation under control without causing a major spike in joblessness. Fed officials often pointed to an excess of job openings and vacancies, believing employers could take those postings down instead of laying off workers they already had.

But even if that hadn’t happened, the Fed’s focus was clear. A key moment came in August of last year, when Powell threw down the gauntlet at an annual economic summit in Jackson Hole, Wyo., warning of the “pain” ahead as the Fed fought to vanquish inflation.

Seven months later, the Fed’s powers were further put to the test by a banking crisis. The swift demise of Silicon Valley Bank and Signature Bank in March sent regulators into emergency mode, worried that the rest of the financial system — and the economy — could descend into free fall.

The Fed managed to keep contagion from spreading further. But it took heat for announcing another interest rate hike just a few weeks later. Critics said the financial system was already under too much strain and that officials were acting before they had a full sense of the crisis.

But for Powell and his colleagues, the move was key to staying on message, and signaled a lasting resolve.

At the Jackson Hole forum this summer, Powell made clear there was still more ground to cover. But by that point, officials had arrived at a different phase of their campaign, where they didn’t need to hike at every meeting and could afford to be more patient.

“As is often the case, we are navigating by the stars under cloudy skies,” Powell said at the time. (It was literally true, too: Many of the central bankers and economists at the conference were caught in a sudden storm while hiking that afternoon. They came back drenched.)

The White House, for its part, deployed a range of tools in service of Biden’s claim that fighting inflation was the administration’s “number one priority” as Democrats clamored to get prices under control.

In October 2021, the administration successfully cajoled ports to operate 24/7 in a push to unsnarl delays that pushed up prices. The White House greenlit significant expansions of oil drilling to lower energy prices, and announced the largest-ever release of the nation’s strategic fuel reserves as gas prices rose, overriding complaints from climate experts and other allies.

Biden vowed not to interfere in the Fed’s campaign to raise interest rates. He rejected calls on the left for more dramatic actions that some economists cautioned could have made the problem worse, such as price controls. Meanwhile, the right demanded that Biden reduce government spending. The White House decided to pursue major new federal programs anyway, arguing that the efforts — on infrastructure, domestic semiconductor production and clean energy — would help inflation by expanding the economy’s productive capacity.

The White House in particular was adamant that inflation was driven by supply chain dysfunction, not by a spike in demand caused by its 2021 stimulus plan, as many critics, including some Democrats, insisted. An analysis by the White House Council of Economic Advisers this fall found that “supply chains in some form” contributed to more than 80 percent of the fall in inflation since 2022.

“There was a certain amount of mockery and derision to Joe Biden saying this transition was possible, as we were getting kicked in the teeth with inflation prints in May and June of 2022,” Deese said, referring to inflation reports. “But we had a pretty clear theory that those inflation prints reflected the high points of the supply shock.”

Indeed, this year finally brought about the long-awaited shifts. Energy prices fell back to Earth. A supply chain rebound helped cool prices for all kinds of goods. A resurgence of workers — including immigrants and women — propelled the economy. Wage gains moderated to a pace that economists saw as more consistent with long-term gains.

Come summer, a picture of 2023’s rocking economy was coming into view. The housing market — among the sectors most sensitive to high interest rates — had come out of a short-lived downturn. People were spending big on Taylor Swift mania, movie tickets and vacations. The White House’s new government programs were injecting additional demand into the economy.

Lael Brainard, director of the National Economic Council, said the White House has looked at how badly the blue chip forecasts missed estimates of growth and joblessness as inflation came down, because many forecasters failed to see how much of the inflation was driven by temporary factors. She emphasized that the conventional wisdom gave too little weight to the role of supply chain disruptions.

“People did not want to see the supply side of the economy as playing as big a role as it did,” said Brainard, who was vice chair of the Fed until February. “You go back to the forecasts from a year ago, and it’s incredible.”

Ultimately, the economy would grow by a whopping 5.2 percent between July and September, stunning economists who had balked at forecasts in that ballpark. Pile on a string of encouraging inflation reports from late summer, and big Wall Street firms repeatedly slashed their odds of a recession.

Broader questions are still unresolved: How long can consumers keep spending en masse? Will the job market eventually take a hit? Will the U.S. economy suffer from any number of geopolitical threats? Something totally unforeseen?

“We kind of assume that it will get harder from here,” Powell said last week, at his final news conference of the year. “But so far it hasn’t.”