Economic Commentary – The Future and Beyond

Over the last 71 years (1952 to 2023), U.S. real household net worth, measured after the negative effects of inflation, has grown at an average 3.6% average rate. Again, there are some notable periods of interruption, but as the charts make clear, they are blips on an otherwise great trajectory.

The cause behind this great trend is Americans’ ingenuity and work ethic up and down the income spectrum, working within an economic system that rewards those who put forth the effort. Human nature has not changed much in thousands of years, and we are confident that the trends above are sustainable.

Distortions Are Disruptive

Projecting where we go from here is complicated by various disruptions we face today. We still have confidence in the long-term trend, but we cannot simply project it forward at an even rate every year.

In several key ways, our elected officials and the Fed have adopted policies that have proven disruptive and impact our economy today.

The fear of a financial collapse in 2008 convinced Congress to pass an unprecedented $700 billion bailout of banks (known as TARP). The Fed began to pay banks interest on the reserves they held while the Fed was increasing the reserves in the system.

The Fed’s actions separated two tools normally used together and in support of one another. Normally (at least until 2008), The Fed changed the money supply and interest rates uniformly to either loosen or contract. Typically, the Fed would increase reserves and lower interest rates to fight recession or decrease reserves and raise interest rates to fight inflation.

In 2008, the Fed increased the money supply amid fears of a financial collapse. So far, so good. Then Covid hit, the economy was locked down for a while, and Congress implemented several stimulus packages. The Fed further increased the money supply and kept interest rates at record-low levels.

But when the crisis was over, the Fed was slow to see the resulting inflation as threatening (calling it “transitory” as recently as late 2021) and did not decrease the money supply nor raise interest rates. It was not until early 2022 when it became clear that inflation was roaring – estimates of 9% per year – that the Fed began to raise rates.

But even as the Fed raised interest rates, it did not withdraw enough money from the system. The theory is that interest rates can help retain excess money in the banks as reserves, preventing its use in the overall economy to drive inflation further.

The combination of massive stimulus, a separation of Fed tools, which normally work together, and the use of interest rates to keep money out of circulation have never been done before in concert with one another.

Where Are We Now

We’ve spilled a lot of ink describing the distortions in the system because they make it more difficult than usual to project forward. Fortunately, we can determine where we are at this point. For the last 16 years (2008 through 2023), the U.S. economy has been growing at an average rate of roughly 2% per year.

Even the most recent data over the last several months of 2023 affirms that. Whether we look at retail sales (up 3.8% on an annual basis), industrial production (up 5.2% on an annualized basis), or housing starts (up 8.6% annualized), most measures paint a picture of continued growth, albeit at a somewhat anemic 2%.

Based on this evidence, if we were to project forward over the next several quarters to a year, we would say there is very little likelihood of a recession. Unfortunately, we must consider inflation and the Fed’s view of all this.

Inflation Is Down But Not Out

We all want inflation to be conquered, and while it has been beaten down over the last several months, it is not yet dead; in fact, there is some evidence it may actually be on the rise. There are various measures of inflation, which complicates getting an accurate fix on it in real-time. The Fed’s goal is 2% per year. Achieving that means the Fed can pause and perhaps look to decreasing rates soon.

September numbers do not seem to support that view. While the Consumer Price Index’s last 12 months ending in September show a 3.8% inflation rate, the last 3 months of data indicate it is now running at a 4.9% annual rate.

The Producer Price Index also seems to affirm this view. Prices are up only 2.2% for twelve months, but the last 3 months show them running at a 7.7% annualized rate.

We do not believe the Fed is finished fighting this fight. The hope is that they know that and will objectively assess what steps to take. The concern is that political calculations will distort that. We aren’t bashing the Fed here; every Fed Board in every administration has looked at both the data and the political landscape.

The market seems to be pricing into stock values one more rate hike in 2023 and then a few tepid rate cuts in late 2024. But the Fed can under-react or over-react, and there is a point at which Fed rate increases can cause a recession. Paradoxically, there is also a concern that the Fed would lower rates too soon.

If the Fed misjudges the inflation battle and starts to lower rates too soon, then when inflation comes back, the Fed would have to start raising them again. Going too low too soon means having to go back up later.

What Does The Short-term Future Look Like?

In the short term, the key question is whether a recession is imminent.

As things stand now – with no changes in economic policy or Fed policy, we see a continuation of 2%-ish growth and only a slight chance of a mild recession, something the market has already priced into current values, which, as of this writing, are still roughly 11% below the last all-time high.

One of the most important factors is what the Fed thinks about the data. Note that it is different than asking what does the data imply? Even if the consensus of economists felt the data said one thing, if the Fed believes it says something different, then the Fed’s opinion will drive policy, which could cause a recession.

We realize this is not a decisive conclusion, but it is honest. The jury is out on the future direction in the short term, but again, we do not believe any recession would be severe given the data and the Fed’s public statements.

What Does The Long-term Future Look Like?

For all the reasons stated at the beginning of this commentary, we believe the long-term future of the U.S. economy, and therefore the markets is solidly positive. The key question for the long term is whether the growth rate stays at a relatively anemic 2% or accelerates to a healthier 3% or more.

There is precedent for both. As the chart below shows, there have been long periods where the U.S. economy grew at 3%, or even more (from the 1960s through 2007), while our most recent 16 years have delivered 2%.

That may seem like a small difference, but over time, such differences compound to represent significant differences. Had we maintained the 3% average annual growth rate, our economy – and, by extension, the stock market – would be approximately 25% larger today.