Coal in the Fed’s stocking last year turned to sugar plums in 2023

WASHINGTON, Dec 18 (Reuters) – The U.S. Federal Reserve
started 2023 on a grim note, with staffers calling a recession
“plausible,” and policymakers penciling in growth near stall
speed and rising unemployment as the costs of quashing inflation
with rapid-fire interest rate increases.

But it ends with the Fed registering faster-than-expected
progress on inflation that occurred with virtually no rise in
the jobless rate and an economy that grew fully five times
faster than the 0.5% policymakers anticipated a year ago. Rate
cuts are now in the offing.

“We were very fortunate,” over the course of the year,
Atlanta Fed President Raphael Bostic told Reuters last week.

What just happened?

Over the year a series of things turned the Fed’s way,
sometimes unexpectedly and not necessarily due to monetary
policy. Just as 2022 was a year of bad forecasts and bad breaks,
including war in Europe, the 2023 economy began looking more
normal after pandemic-era excesses. It redeemed, to some degree,
early Fed thinking that high inflation would ease over time
without the central bank squelching growth altogether.
Actions taken by the Fed included an emergency lending
program for banks that helped ease financial sector tensions at
a key point. There were also legitimate surprises like a rise in
productivity, and other developments tied to the economy’s
underlying performance, like the increase in the labor force.
“Institutions have evolved and opportunities have become
sufficiently attractive that people have come back in strong. I
was not expecting that. That’s very positive,” Bostic said.

The forecasts still weren’t great through an uncertain and
volatile period. But this time the surprises were mostly to the
good.

MONEY FOR NOTHING, CHIPS FOR A FEE

Fed Chair Jerome Powell stopped using the word “transitory”
to describe inflation long ago, but last week he described,
without saying it, why that belief took hold.

The pandemic had dumped trillions of dollars of aid into
consumers’ hands, stoking demand that hit a wall as the global
goods supply chain became stilted by that same pandemic.
Shortages of basic industrial goods like computer chips kept
inventories bare and allowed rising prices to ration what was
available.

This year saw supply pressures unwind as inventories
rebuilt, perhaps to excess. Goods prices began to drag headline
inflation lower, as was often the case before the pandemic.

Labor supply also surprised to the upside. After concerns
early in the pandemic that women’s ability to work had been
permanently scarred, the number of women in the workforce hit a
record high. Rising immigration helped even out what had been a
historic mismatch between the number of open jobs and the number
of people looking for work. The boost in the labor force and
drop in job openings have helped slow wage growth that some top
economists worried was on the verge of driving inflation higher.

HOUSEHOLDS HOLD THE FORT

While the gusher of pandemic aid may have helped push up
prices from high demand, the financial buffers built by
households and local governments had more staying power than
many economists expected. Over 2023, long after pandemic benefit
programs had ended, there were still estimates of hundreds of
billions of dollars left to spend.

That showed up in consumer spending that consistently beat
expectations. Though recent data suggests demand has finally
begun slowing, the surprising resilience of household spending
was a key reason the Fed’s initial growth forecasts proved low.

A PRODUCTIVITY BONUS

All things equal, that unexpectedly strong jump in gross
domestic product should be inflationary. The Fed estimates the
economy’s underlying growth potential is around 1.8% annually,
so 2023’s estimated 2.6% expansion seems out of kilter.

But “potential,” at least for now, may have been lifted by a
jump in worker productivity. Rising productivity is manna for
central bankers, allowing faster growth without inflation
because each hour of work yields more goods and services at the
same cost.

It is also something they are reluctant to predict or rely
on. In this instance, however, it helped Powell drop what had
been steady references to the “pain” needed to subdue inflation
through rising unemployment and instead talk more openly of the
relatively pain-free disinflation apparently underway.

Today’s unemployment rate is 3.7% versus 3.6% when the Fed
began raising interest rates. It has been below 4% for 22
months, the longest such run since the 1960s, and roughly what
prevailed just before the pandemic, a period Powell heralds
frequently.

THE BANKING CRISIS THAT WASN’T

A final surprise is how contained the spring’s round of bank
failures proved to be after the rapid collapse of Silicon Valley
Bank. Those tremors prompted new caution among Fed policymakers
about the speed of further rate increases, and led to warnings
of a deep financial fracture as banks took stock of the fact
their holdings of government and mortgage securities had lost
value due to Fed rate hikes.

Certainly there was stress. But it didn’t evolve into a
broader crisis and stayed in line with what the Fed was trying
to do anyway: Tighten credit to cool the economy.

Indeed, following what proved to the Fed’s last rate
increase in July, markets began doing some of the central bank’s
work for it by driving borrowing costs higher than the Fed
anticipated doing with its own rate.

Market rates are now falling, some dramatically, as the Fed
pivots towards rate cuts. Will the markets go too far?

Fed officials are conscious of the time it takes for changes
in financial conditions to work into the real economy. Recent
weeks have seen increases in loan delinquencies and other signs
of household stress, while there was also worry about the amount
of corporate debt that needs to be refinanced, and the trouble
that could cause companies if rates are unaffordable.

The Fed’s “soft landing” scenario won’t be assured unless
the central bank, as Powell noted, doesn’t “hang on too long” to
its current restrictive policy.

“We’re aware of the risk,” Powell said last week.

WILL THE GOOD NEWS CONTINUE?

Powell also said he thought some of the forces working in
the Fed’s favor, particularly supply improvements, have “some
ways to run.”

Inflation for the past half year has only been about 2.5%,
with strong arguments for it continuing to fall.

In the Fed’s most recently released policy documents,
officials tucked in a subtle statement about their faith in the
economy’s return to normal. An index of risk sentiment fell
towards a more balanced view, with inflation even seen by a
number of officials as more likely to fall faster than to move
higher.

(Reporting by Howard Schneider; Editing by Dan Burns and Andrea
Ricci)



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