A Resilient Economy Faces Substantial Policy Risks

The economy grew at a substantial 2.9% in inflation-adjusted terms in the last quarter of 2022. This faster-than-expected performance occurred amid substantial headwinds, mainly higher interest rates. But, continued monetary policy tightening and, more importantly, massive fiscal policy uncertainty over Republicans’ stance on allowing the federal government to pay its bills could derail the economy and push it into a recession.

Today’s economic release from the Bureau of Economic Analysis includes a number of good news worth highlighting since they reflect substantial resilience in the face of massive obstacles. he economy grew at a meaningful 2.9% in the past three months of 2022. Notably, consumer spending barely fell from its pace of 2.3% in the third quarter to 2.1% in the fourth quarter of last year. Consumers spending on goods such as cars, furniture and medication increased again after declining by 0.4 percent in the previous quarter. And, spending on services such as utilities, housing, health care and going out to eat slowed but still grew at a robust 2.6% rate.

Two factors helped support consumer spending at the end of 2022. First, inflation moderated. The price index for Personal Consumption Expenditures – the Federal Reserve’s preferred inflation measure – increased at 3.2% in the fourth quarter, down from 4.3% in the third quarter. This drop in inflation freed up money for consumers to maintain their spending on necessary things such as housing and health care. Second, personal non-inflation adjusted income outpaced inflation as it grew at 5.6% in the last three months of 2022. After-tax income grew even faster at 6.3%, boosted by “stimulus payments in the form of one-time refundable tax credits”. Still, wages and salaries also grew faster than inflation with 4.9% in the fourth quarter, reflecting a very robust labor market with near record low unemployment and continued wage gains. Economic performance remains solid as the threat of inflation subsides and households continue to see more money in their wallets.

It was not just households that boosted economic growth. Business spending also did its part. Business spending on intellectual property such as software increased by 5.3% in inflation-adjusted terms. Investments in inventories also accelerated, contributing 1.46 percentage points to the overall growth rate at the end of 2022. These factors likely suggest that businesses see continued growth ahead and thus want to be prepared for the growing demand.

This was not all in terms of good news for the economy. Imports fell faster than exports and federal government spending on nondefense items jumped at the end of the year. U.S. businesses and consumers imported a lot fewer computers and industrial supplies. This could be a sign of a shift to more domestic production, but also of declining demand for computers, for example. At the same time, more foreign visitors to the U.S. meant more exports of travel and transport services. Furthermore, the increase in the federal government’s nondefense spending reflected double digit spending increases in structures such as office buildings, but also on software. Similarly, state and local governments increased spending in all categories – structures, equipment, research and development, among others, at the end of the year. These spending increases start to address substantial infrastructure shortfalls and were likely aided by President Biden’s various signature pieces of legislation such as the American Rescue Plan Act and the Infrastructure Investment and Jobs Act. These bills provided much needed money to state and local governments and massively boosted infrastructure investments across many areas.

The data, though, also highlight some of the risks that the economy faces. Consumer spending overall has slowed. Households have also cut spending on housing by 26.7% in the fourth quarter after it fell by 27.1% in the third quarter. The decline in housing is the clearest sign of the adverse effects from higher interest rates due to the Federal Reserve’s aggressive monetary tightening.

Higher interest rates, especially the danger that the Federal Reserve will go too far in slowing the economy, are not the only risk. The fiscal recklessness of the new Republican majority in the House of Representatives could meaningfully slow several of the factors that currently contribute positively to economic growth and thus raise the risk of a recession. This homemade policy risk could further reduce the value of the dollar and raise the prices of imports. It could stall business investment and it could slow government investments. As a follow on, job and wage growth could slow and thus depress consumption spending. The economy is currently very resilient in the face of substantial challenges, but that resilience can only overcome so many hurdles. Political gambling with the government’s financial standing by House Republicans may be one hurdle too large.