Evening Brief – 05.31.23

The economy remains too strong for the Federal Reserve’s liking. The argument for holding off on interest rate hikes rests on the assumption that the overall effects of tightening policy and any resulting lags will be sufficient to further stifle nominal economic growth and inflation in the future.

That cumulative tightening must also not be enough to throw the US economy into a recession—real growth, while positive, has been weak since 2022. Over the last year, Nominal Gross Domestic Product (NGDP, the dollar size of the American economy) has grown by nearly 7%, but growth was only 1.6% after adjusting for inflation.

But NGDP growth slowed considerably throughout 2022, reaching the lowest level since the start of the pandemic in the first quarter of this year. It’s still too high for comfort – 5% annualized, compared to the roughly 4% level that would be consistent with 2% inflation and closer to pre-COVID norms.

The US has now recorded three straight quarters of positive real growth, a year after the two consecutive quarters of negative GDP growth that gave rise to the height of recession fears. The Q1 GDP number was stronger than it originally seemed, albeit being low.

In general, we are still seeing some of the cyclical nominal growth slowdowns required to bring inflation back to target, but not all of what is required, and to the extent that underlying economic data continue to come in hot, it will take longer than previously anticipated for the Fed to accomplish its goal.

However, a lengthier and more gradual cool down also reduces the likelihood of the kind of sudden economic collapse that has been most anticipated since the Fed started tightening policy last year.

The most likely result of the next FOMC meeting will be that participants will once again be forced to modify their estimates, both by extending the time before which they expect an economic recession and by reducing the extent of the contraction they expect.