Main Street Macro: What non-economists get wrong

Economists sometimes get their forecasts wrong. First, we say inflation will be transitory. Then we say there will be a soft – no, wait! – a hard landing. A recession! Or maybe, definitely, a soft landing.

I get it. But many prognosticators and everyday decision-makers who aren’t economists get some things wrong, too. As we enter a week full of data on the labor market, here are three things people commonly get wrong about the economy, and why.

Higher interest rates spell recession

Former Federal Reserve Chair Ben Bernanke once remarked, “Recessions don’t die of old age. They’re murdered by the Fed”.  

You might have heard me use this quote before, because it’s one of my favorite Fed quotes of all time. It succinctly captures how a business cycle works.

Here’s how that cycle typically plays out. Fed policymakers sense the economy is running hot. They raise interest rates to prevent inflation from picking up steam. That chokes consumer demand and causes the economy to slow. Eventually, it dips into a downturn.

But here we are, with interest rates at a 20-year high and the economy chugging along, outwardly oblivious to nearly two years of Fed tightening. In 2023, the economy grew by a solid 3.1 percent.  So far this year, according to the Fed, growth is tracking at 2.1 percent for the first three months. Yes, growth has slowed, but we are far from a recession.

It might be that higher interest rates no longer cause the economy to crumble the way they have in the past. One theory is that the U.S. economy has become less rate sensitive. In the past, U.S. growth was led by manufacturing and housing. Consumer demand for big-ticket items in these industries were interest rate sensitive because they typically required a purchaser to borrow.

Before 1970, the sale of goods dominated consumer spending. Over time, consumers directed more of their household budgets toward services. By the fourth quarter of 1969, consumer spending made up 60 percent of real GDP, and personal expenditures had become equally distributed between services and goods.

In the years that followed, more and more of the consumer budget was allocated to services. Fast forward to more recent decades, and consumer spending on services is double that of spending on goods. The service sector, which includes health care, restaurants, travel, and entertainment, is less sensitive to interest rate movements.

What goes up must come down

We’ve all experienced how gravity works. When something goes up, it’s pulled back down to Earth. 

The economy doesn’t work like that. When prices rise, they often stay high. So even though inflation has been trending down of late, it doesn’t mean prices will fall, especially for high-cost outlays such as housing, medical expenses, and tuition.

So, despite the Fed’s tremendous progress on slowing down price increases, the goods and services we buy as a whole are still 17 percent more expensive than they were four years ago, according to the Bureau of Labor Statistics. 

BLS data also shows average weekly wages are up a bit more than that, 20 percent now versus four years ago. Higher wages have provided support for higher prices.

Fixing inflation comes at the cost of jobs

This week we will get the ADP National Employment Report on Wednesday and the BLS non-farm payrolls report on Friday. What we’ve learned from a year of crunching employment numbers is that you can fix inflation and grow jobs and wages.

Even with higher interest rates, employers of all sizes have been adding jobs. Wage growth is stronger now than it was before the pandemic, when inflation was low. The unemployment rate is still near record lows.

While we’ll get a fresh read on the job market this week, we’ve already seen that the labor market can continue to add jobs even amid higher interest rates and elevated, if decelerating, inflation.

My Take

I recently met a famous astrophysicist. His job is to explain the workings of the universe. Upon hearing that I was an economist, he said, “physics and math are a lot more determinant than economics is.”

That statement made an impression on me. While the physical universe is driven by cosmic forces that occur over billions of years, economies are guided by billions of individual, personal decisions that are impossible to predict perfectly and difficult to capture in real time.

That’s what makes economics, to me, so interesting. It’s easy to get wrong, because the economy is always changing.

In some ways, we are all economists. Whether we’re shopping, holding down jobs, or running businesses, we’re all trying to make sense of our day-to-day economic activity and use what we know now to prepare for what’s ahead.

As I see it, my chief job is not to make forecasts. It’s to provide context, data, and insights that can help people make today’s hard decisions in anticipation of a yet-to-be-determined future.