An expert’s guide to what’s happening with the U.S. economy and why you should care

Today’s economic climate can feel like a series of contradictions. Inflation is decelerating but the Fed raised interest rates again; businesses are complaining the economy is slowing, but the economic data remain decent; and finally, the unemployment rate is once again at a 50-year low and job growth is strong, yet consumer confidence is in the dumps.

Does any of this make sense? The United States is entering a crucial period in this economic cycle, so let’s break down what’s actually happening.

Let’s start with the Federal Reserve raising interest rates again in May. In a little less than 14 months, the monetary authorities have taken short-term rates from nearly zero to over 5%.

That raises two critical questions: Why are they continuing to increase rates, and when will they stop raising rates?

First the why. For the Fed, it is all about inflation. COVID, supply chain issues, government fiscal policy, business and labor pricing power, and the war in Ukraine all combined to send the inflation measures off the charts. Fed Chair Jerome Powell has stated on numerous occasions that “without price stability, the economy does not work for anyone.”

Consequently, the Fed is following a simple strategy: Keep at the fight against inflation until the job is done.

After a year of fighting, why isn’t the war over? Higher interest rates have slowed the economy, but it takes time for the effects to be seen. The lag is somewhere between six and 12 months before a rate increase has an observable impact on economic activity. In addition, the Fed started at extraordinarily low rate levels. It had to get to a point where rates were high enough to alter consumer and business borrowing decisions.

Yes, inflation has decelerated since the Fed started its tightening policy, but it is still over twice as high as its target of 2%. And critically, the Fed needs to be certain it has put out the fire, not just gotten the conflagration under control. It will not likely know if the rate hikes have succeeded for at least another six to nine months.

As for when the Fed may stop raising rates, we may be at that point already. Given the time it takes to see the impact of interest rate changes on sectors such as housing, motor vehicles, business investment, and household borrowing, the central bank has tightened enough that it could reasonably stop for a few months and see what happens. But remember, the Fed is raising rates to get inflation back under control, so if price increases don’t decelerate significantly, future rate hikes are possible.

Next we turn to the dichotomy of businesses complaining about an economic slowdown while the economic data don’t show that moderation is actually happening.

OK, the economy seemed to soften in the first quarter of the year. Gross Domestic Product (GDP) growth was only 1.1%, a pace that looks like stagnation. So why am I saying that the data don’t point to a major softening in growth?

As is usual, the important information is not in the headline number but in the details. Consumer spending was robust in the first quarter, especially for big-ticket durable goods, such as appliances and electronics. Purchases of services, which is over 60% of total personal consumption, was also strong.

It wasn’t just consumers driving growth. Business spending on buildings and intellectual property jumped, exports surged, and all levels of government spent more.

The weakness was in two major areas. Not surprisingly, home construction faltered as mortgage rates rose sharply. The Fed’s actions are working.

The second area was inventories. Stocks of goods in warehouses fell sharply, reducing GDP significantly. Excluding the inventory decline, the economy expanded strongly.

When interpreting changes in inventories, economics goes from science to art. A decline or increase in inventories could mean almost anything. The fall in inventories could have been the result of firms underestimating growth and not having enough stock to meet demand. On the other hand, the fall might have resulted from fears of the economy softening so firms prepared for a slowdown by reducing stocks.

Currently, it appears firms are worried about a potential downturn and slashed inventories to ensure they are not stuck with excess goods in warehouses. While that reduced first quarter growth by nearly 2.3 percentage points, it may soften the blow if the economy does falter. Firms are already adjusting for potentially weaker future demand. Orders and production would still decline if a recession materializes, but the precautions presently being taken should cushion the drop.

Though growth is only slowly fading, firms are worried about the future and reacting accordingly.

Finally, there is the contradiction of a drum-tight labor market but depressed consumer confidence. When households are not worried about their jobs, they tend to be happy campers. Well, there are tons of job openings, hiring is robust, and the unemployment rate in April fell back to the lowest level in over 50 years.

Also, when people are worried, they generally don’t spend money, but right now, many people are spending like crazy.

In spite of this, households are saying they are depressed. The University of Michigan’s Consumer Sentiment Index is at a level normally seen in recessions.

The strong labor market and robust consumer spending are clues that the discontent isn’t largely related to economic issues. Yes, the low level of consumer confidence reflects the impact of inflation on household budgets. But sentiment has been greatly impacted by noneconomic concerns such as the political dysfunction in Washington, extremism, gun violence, and culture wars. Thus, as long as the job market remains strong, households will not likely abandon shopping on the internet or at stores.

What does all this mean for the economy? The Fed should be on hold for an extended period, but inflation needs to decelerate rapidly enough to keep the central bank from raising rates again. If it does tighten further, the strength in the labor markets and consumer spending should cushion a possible recession, but probably only enough to prevent it from becoming a major downturn.

One final comment: All this will be irrelevant if the debt limit is not raised. But that is for a different discussion.

Joel L. Naroff is the president and founder of Naroff Economics consulting firm in Margate. jnaroff@inquirer.com