The whiplash has left consumers and businesses wondering: When will prices come back to earth? And are we headed toward a steep economic downturn?
In a recent The Insightful Leader Live event, Kellogg finance professor Sergio Rebelo walked us through various indicators to help diagnose the health of the economy. Here are a few takeaways from his presentation.
Employment has bounced back …
It took more than six years for the U.S. to recover the jobs lost during the 2008 financial crisis—a painful stretch fresh in policymakers’ minds when Covid hit. “We fell off a cliff and returned in terms of employment to the dark times of 2010,” says Rebelo. “The worry was it could take years to get back to the employment we enjoyed in 2019.”
So this time around, in addition to U.S. and European central bankers slashing interest rates to zero—or even below zero—governments stimulated demand with massive increases in government spending.
Consumer demand recovered quickly—and so did employment. U.S. unemployment shrank to just 3.5 percent, a very low rate by historical standards, in a little over a year.
… But worker shortages remain
Still, the rebounding economy is now constrained by long-term demographic trends. Thanks to decades of lower birth rates and slowing worker migration, the population of active workers aged 25–54 has plateaued in developed economies. “Fertility rates are currently below the replacement rate, so we are sowing the seeds of a future labor shortage,” says Rebelo. He jokingly suggests a renewed commitment to the slogan “make love, not war.”
Before 2016, the U.S. made up for declining fertility rates with immigration, “but that channel has been greatly reduced,” dropping from about a million immigrants a year to just 200,000.
Supply-chain constraints are easing
Data on global supply chains and product availability also offer a mixed picture.
There are certainly still some supply squeezes. New-car inventories remain extremely low, partly because of ongoing semiconductor shortages. If you’re shopping for a car, it’s best not to be picky about colors because “you are not going to have a lot of choices,” says Rebelo. Still, used-car prices are falling, suggesting that supply and demand are coming into closer balance. “That will help inflation go down.”
The pandemic-caused spike in shipping costs is also normalizing. The price of shipping a 40-foot container of goods from China, which was $1,400 in 2019, soared to an eye-popping $10,000 in February 2022. Now, it costs around $2,100.
Food and fuel prices are moderating
Over the past year, supply-chain woes and Russia’s invasion of Ukraine combined to send commodity prices for food and fuel sky-high.
An index of inflation-adjusted food prices recorded its highest-ever spike in 2022. “This spike was awful news for emerging markets because it means that many children will suffer from malnutrition,” says Rebelo. But food prices are starting to normalize, he adds.
Fuel prices have also adjusted. “By and large, the oil market has rebalanced,” says Rebelo. “Sanctions on Russia are having an impact: Russian oil is selling at about a 30 percent discount.” Shortages of natural gas, which is critical in Europe for both heating and power, have, at the moment, eased.
Rebelo also points out that retail prices for food and energy are not coming down as quickly as falling commodity prices would indicate. That’s due to the so-called “rockets and feathers” phenomenon, explains Rebelo. Retailers are quick to raise prices when their costs go up but act much more slowly when those costs come down.
The housing market is on a precipice
In its attempt to control inflation, the U.S. Federal Reserve raised the federal-funds rate to 4.33 percent, up from close to zero during the Covid crisis, and stopped its bond-buying program. As a result, mortgages have become much more expensive.
“Rising mortgage rates might not have an immediate impact on the housing market, but as time goes by, it can have a sizable impact,” says Rebelo. Higher mortgage rates have already caused home-sale volumes to drop off.
Home prices, which soared 20 percent in 2022, are poised to come back to earth, or at least back in line with rents. “Rents and house prices should roughly move together in the long run,” says Rebelo. Globally, the costs to rent versus buying a house started to diverge in 2020, at the beginning of the pandemic. “We might be up for some realignment ahead.”
The Fed is watching wage growth
Economists expect the U.S. Federal Reserve to continue to raise interest rates in 2023, likely to around 5 percent.
As the Fed makes decisions about rates, it will look closely to wage growth, hoping to avoid a prolonged price–wage spiral. That happens when rising prices cause workers to demand higher wages, leading companies to raise prices further to pay workers, and the cycle continues. “When people expect inflation to continue, they will keep rising prices in the future. If we don’t stop inflation, it can become endemic,” says Rebelo. Wage growth increased throughout 2022 but is now slowing.
Sharply rising interest rates can trigger a recession and job losses. Already, the slope of the yield curve—the yield on a 10-year bond minus the yield on a 3-month government bond—has become negative, suggesting investors expect interest rates to go down in the future as the Fed responds to a recession.
The Fed’s path forward will not be easy. After all, it takes a while for the economy to react to new, higher interest rates. “Imagine driving a car where braking slows the car down only after a delay period. To avoid people in the car screaming, you have to brake multiple times,” warns Rebelo. “You have to convince passengers you are a safe driver.” As the Fed continues to brake to convince consumers and businesses that it is a safe driver, it might tip the economy into a recession.