The search for the economic crystal ball

US President Harry Truman (in office from 1945 to 1953) is credited with having said: "Give me a one-handed economist!" This quote reflects the reality that when making predictions, economic forecasters often speak in terms of probabilities, relative concepts and baseline scenarios, and not in more direct, absolute conclusions. 

In their defence, economists do not work with mystic, crystal balls that reveal the future with certainty, but rather with complicated mathematical models that can never be totally accurate. This guaranteed lack of 100 per cent accuracy results in the two-handedness of making economic forecasts that irritated President Truman.

While not a crystal ball by any measure, past outcomes under similar conditions as the present can be a useful guide in terms of what will happen next. Specifically, history has shown repeatedly that when central banks increase interest rates (and especially if they do so rapidly), inflation tends to fall but there is a significant risk that the economy will shrink as well. 

Rapid rate hikes

Put differently, central banks make difficult decisions: high inflation acts as a tax on everyone in an economy, and especially hurts low-income households and those with financial savings. In a bid to limit the harm caused by rapid price increases, a central bank may engineer a few successive quarters of negative GDP growth. 

These recessions are usually accompanied by an increase in unemployment, and it may take many quarters before the previous level of employment is reached again. The thinking is that the shorter-term social pain of job losses will be overshadowed by the gains achieved with a stable, low inflation rate over the long term. 

Turning to the present, the US Federal Reserve hiked benchmark interest rates by 500 basis points from early 2022 to July 2023, compelled to do so as inflation surged in the wake of the Covid-19 pandemic. At the time, conventional views on economic theory suggested that a recession in late 2023 or early 2024 was almost a "crystal ball"-level certainty. Indeed, this rate hiking cycle was that fastest in US history, so all else being equal, thinking that a recession was avoidable would have been a rather heterodox view.

Inflation: what happens next? 

Yet, in just the first quarter of 2024, the US economy has added 829 000 jobs. This brings the total jobs recovered since the low point of the pandemic (reached in April 2020) to a cumulative gain of twenty-seven million jobs. The US unemployment rate sits at 3.8 per cent, which by US standards is very low. With wages still climbing, according to the Atlanta Federal Reserve Board, at approximately 5 per cent year on the year in March 2024, household spending in the US is especially buoyant.

The current combination of falling US inflation, reasonable economic growth and low unemployment is a very benign outcome, in our view, when set against the historic surge in interest rates. The more important question to ask is: "what happens next?"

Debate over US debt level

As a result, the US government's federal debt as a ratio to GDP is set to breach the 100 per cent mark in 2024. Should present trends continue, the Congressional Budget Office estimates that by 2054, the debt-to-GDP ratio could reach 166 per cent. (To put this number into context, shifting to a war economy setting during WWII saw the debt jump to 100 per cent of GDP, but this was the only period in modern times to witness such high debt accumulation.)

It is important to remember, however, that such predictions are very sensitive to changes in an array of underlying assumptions. Over the coming years, we expect to see heated debate about how public healthcare programmes and social security are financed, for example. That in turn will likely have a direct impact on the path of the US federal debt. For now, however, financial markets have yet to solve the riddle of stubborn US CPI, and by extension the timing of US rate cuts, if any.