How is the US economy adjusting to macro shifts?

The US has been hiking rates since March 2022 and has since hiked rates by 450 basis points in the last 11 months. One of the big fears in the global market has been whether this would eventually translate into an economic slowdown in the US and in other advanced European markets. The US GDP data has actually shown a positive turnaround after negative GDP growth in the first two quarters of 2022. 

However, the lag effect on growth is expected to growth towards the end of 2023. For now, the US Fed is obsessed with getting inflation back to 2% and has almost refused to relent with its hawkish policy till then. However, in a recent speech, Christopher Waller, a member of the Federal Reserve Board of Governors has sought to dispel the notion that growth would be hit. In fact, Waller has gone to great lengths to underline that the US economy was adjusting quite well to macro shifts.

What Governor Waller said about the US macro adjustment

Christopher Waller had been one of the early proponents of the hawkish theory to curb inflation, even at the cost of growth. That is a theory that even the Fed chief, Jerome Powell, has been subscribing to in the last one year. However, one macro concerns arise from the fact that the yield curve has turned negative. A negative yield curve shows uncertainty over the long term and preference for the short term; a classic lead indicator of recession. Here are some of the key points that Governor Waller made in his recent speech.

1. Waller underlined that the US economy was adjusting fairly well to the higher interest rates triggered in the US to rein in inflation. At a policy level, Waller underlined that while growth was impacted in 2022, inflation continued to remain elevated. That made a case for the Fed to retain its hawkish stance, at least till the end of 2023.

    

2. One of the main reasons why the Fed was likely to continue with the hawkish policy was the stronger than expected labour data. The US economy had created 11 million jobs in the last two years and the unemployment had fallen to a low of 3.4%. As a result, the higher interest rates were not immediately translating into lower inflation since the strong labour data was creating a demand slack in the US economy. With this inflation stance of the Fed, the question is about its impact on GDP growth of the US economy.

    

3. But, even before getting to the growth story, there are some positive vibes form the US economy on the inflation front. For instance, there has been a normalization of spending on groceries in 2022, compared to the COVID years of 2020 and 2021. That is the first sign that the demand driven inflation in consumer goods could be on the way down. Waller is of the view that while strong labour data may make inflation control slower, it is a positive trigger for growth, since it shows companies can afford higher wages.

    

4. Waller acknowledged that higher interest rates did pose a challenge for farmers and ranchers who borrow to smooth out the costs and returns from agriculture over the year. As Waller summed up the inflation intent of the Fed; their first job was to get high inflation off the front pages, and back to being something that households and businesses don't think too much about when making decisions. That would make it possible to address the growth issue more easily. After all, unemployment at 3.4% is the lowest level since 1951 and indicates that while inflation transmission may take longer, it was unlikely to impact growth in any serious way.

    

5. On the growth front, Waller underlined that the problem of the US economy was not nominal growth, but real growth. Now, real growth is a function of inflation, so as inflation trends lower, the real growth is automatically higher. Typically, the monetary policy works with a lag. For instance, the Federal Reserve started raising interest rates in March 2022, but inflation peaked in the middle of 2022. Since then, inflation has been falling consistently, directly translating into higher real GDP growth. 

    

6. Waller has suggested the need to focus less on headline inflation and more on core inflation. Now, core inflation is the residual inflation after stripping out food and energy prices. Since food and energy prices tend to be volatile, they are too vulnerable to the base effect. Hence, they may not always provide a good signal of how inflation could evolve over time. The good news is that core inflation in the US never rose as much as headline inflation since it was food and energy that provided all the volatility. 

In this background, is there reason for the Fed to be paranoid about negative growth in the US economy. The Fed has consistently underlined, and Waller has also reiterated the fact, that much of the problems were with real growth and not with nominal growth. Hence, the real villain of the piece was inflation and not growth per se. The solid labour data has been largely indicative, not only of the slack in inflation transmission, but also of the underlying spending capacity of American corporates. That is good news.

The moral of the story, as emerging from Waller’s address, is that real growth may be more of an outcome than a trigger. Strong labour data suggests that nominal growth is still robust. To boost real GDP growth, Fed needs to bring down inflation and for that they need to bring down inflation expectations. That is only possible through consistent hawkishness.