Economic Prospects For 2023

Surely I am not alone in feeling as if the last several years were a blur. It was like being on the beach and getting knocked down over and over by successive waves–just when it looked as if you might be able to stand up again, another one came crashing in. What, pray tell, does 2023 have in store for us?

No one knows for sure, of course. Who could have predicted COVID in 2020, the attack on the Capitol in 2021, or Putin’s invasion of Ukraine in 2022? But what I can say with relative confidence is that, even if a new wave doesn’t knock us off balance again, those cataclysmic events of the past three years will continue to have an impact on our lives in 2023.

INFLATION

The top story continues to be inflation. Unfortunately, while it appears to be decelerating, the underlying causes remain. These are (as I have argued elsewhere) the production and supply chain problems created by COVID and the reduction in food and energy production resulting from Russia’s invasion of Ukraine. The economics behind this is fairly simple: when you reduce the supply of a good or service while demand remains unchanged, the price increases.

The table below tracks the progress of inflation since COVID (CPI numbers are compounded annual rates of change). As you can see, inflation was fairly tame before the pandemic spread and was actually negative in second quarter 2020. That was, of course, a result of the fact that demand didn’t remain unchanged that quarter, it collapsed.

Lockdown followed thereafter, continuing to depress demand. However, as things began to open back up in 2021, prices accelerated. This was both because demand was recovering and, more importantly since demand was no higher than it had been in 2019Q4, supply contracted. Not only were there continued reductions in production in various key areas like computer chips, but oil production was reduced both by the pandemic and by choice.

We therefore endured high rates of inflation throughout 2021. We were all hopeful of some relief in 2022 when it was assumed that production levels would start to recover—and then Russia invaded Ukraine. This not only created uncertainty, but it further reduced oil supplies and caused interruptions in grain shipments. The impact on inflation is shown above.

While December data have yet to be published, things do appear to be moderating. That said, 5.7% is simply better, not good. You would have to go back to September 2017 to find a higher rate (6.3%) and then February 2013 after that (6.7%). Why does inflation remain so high? Simple: the invasion is still ongoing and the effects of COVID continue to linger. Indeed, the latter may resurge as the impact of China’s mismanagement of the crisis makes itself felt.

Given all this, what is my bold prediction for 2023?

• Inflation may moderate to 4% or so, but the essential problem will not go away until supplies return to what they were pre-COVID and pre-invasion. There is no reason to expect that to happen very quickly, or even at all if Russia continues the invasion.

INTEREST RATES

“But,” you might say, “isn’t our government already acting bravely to try to reduce consumer price inflation?”

Unfortunately, yes. What they are undertaking is contractionary monetary policy in the form of higher interest rates, and they are expected to continue pursuing this policy for some time. Their logic is that if they reduce people’s incomes, this will lower inflation. That’s true enough, just look at 2020Q2 on the table above to see a quarter where prices actually fell despite COVID. It turns out that 13% unemployment can lead to deflation!

But that’s treating the symptom rather than the disease. It’s like putting someone with a fever caused by a deadly infection into a bathtub full of ice—yay, their temperature went down! Now they’ll die nice and cool.

As explained above, the underlying issues are the shortages caused by COVID and the invasion. Neither of these is in any way directly addressed by reducing Americans’ incomes. Sure, the prices come down because we don’t have as much money to buy stuff, but that’s not a solution, it’s a smoke screen. Incidentally, the prime rate—the rate banks offer the most creditworthy customers—has now gone from 3.25% on March 14 of last year to 7.5% today. It has more than doubled in less than a year.

My bold prediction for interest rates in 2023:

• They will continue to rise throughout the year as the Federal Reserve tosses more gasoline on the fire in the hopes that it will douse the flames. If they think the policy is working, maybe we’ll see 8.5% by the end of the summer; if not, 9.5%.

GDP GROWTH

Last summer, some concerns were raised regarding whether or not the US was in a recession. Those arguing “yes” pointed to the two consecutive quarters of negative real GDP growth in 2022Q1 and 2022Q2. That is not, however, the official definition of a recession, only a rule of thumb suggested by economist Julius Shishkin in a 1974 New York Times article. The official definition leaves a great deal of room for interpretation, and only one group is permitted to make that interpretation: the National Bureau of Economic Research. All that said, the discussion died down when third quarter 2022 was actually much improved at 3.24%. In addition, unemployment remains below 4%.

That doesn’t necessarily mean that we’ve nothing to worry about in 2023, however. What concerns me more than the GDP data are those for inflation-adjusted physical investment spending in our two most recent quarters of 2022Q2 and 2022Q3 (we don’t have data for 2022Q4 quite yet).

To give you an idea of why this is on my mind, take a look at the figure below showing the pattern of physical investment spending just before the ten post-World War Two recessions (the grey areas) before COVID.

Notice the pre-recession behavior of firms’ additions to their productive capacity and inventories (i.e., investment): it is falling in almost every single one. The two outstanding exceptions are recession 6, which might otherwise have been avoided had it not been for the 1973 OPEC oil embargo, and recession 8. The latter is of particular importance right now because it resulted from the Fed’s anti-inflation policy that led to prime interest rates over 20%. The result was a peak unemployment rate that remains the post-war high, save for that experienced during the COVID recession.

The situation facing us today is we have both declining investment spending and a central bank policy that is taking a page out of Paul Volcker’s book (Fed Chair during recession 8—the one named after him). This is why I have concerns regarding a downturn in 2023. And while we avoided negative GDP growth in 2022Q3 (after negatives in the previous two), this was because of fortuitous and likely unsustainable positive contributions from consumption spending and net exports. I say unsustainable because if the Fed’s policy is successful, then the former will fall, plus we already have indications that US trade performance suffered in fourth quarter.

Having said all this, something that could easily serve as a counterweight is government spending. The federal government is the only player that doesn’t face a budget constraint so that they can act quickly and strategically to reverse any negative trends. Of course, this would require those in charge of our government to cooperate and be pragmatic and truly concerned with the plight of their constituents. I don’t think anyone would argue with me that we were a long way from that even before January 6, 2021.

My bold prediction for GDP growth in 2023:

• Initially around 2% and a recession at least by 2023Q3.

CONCLUSIONS

Our 2023 will be—barring the emergence of a brand-new disaster—driven by our 2020, 2021, and 2022. The inflation resulting from COVID (2020) and Putin’s invasion (2022) remain with us and will do so for some time. Worse still, it has convinced the Federal Reserve that the best thing to do right now is to reduce the overall level of economic activity. That, on top of the cyclical decline in investment spending, suggests that recession could be around the corner. Of course, all of this could be at least mitigated by decisive and coherent government policy. An attempted coup d’etat (2021) and the failure of the Republican party to elect a Speaker of the House today (the first such failure in 100 years) suggests that we may not see that any time soon.

Perhaps worst of all, none of this even begins to address the real elephant in teh room/existential threat that is climate change.