Pundits and "the economy"

Flawed models lead to bad forecasts

Long-time readers know that I’m obsessed with soft landings. America has never had one. Other countries have had them. I have frequently asserted that there was no reason why we could not have one too. All we needed was sound monetary policy.

Now, we seem to have achieved a soft landing. For the first time in American history, we’ve had three consecutive years of cyclically low unemployment without an upsurge in inflation. Indeed, the rate of inflation has fallen sharply since 2022.

Unfortunately, both media and much of the economics profession has no idea how to interpret this situation, as they don’t put enough weight on the role of monetary policy. This tweet suggests that economists see a mystery in need of a solution:

Recall that macroeconomics consists of three primary domains:

1. The business cycle

2. Inflation

3. Long run real GDP growth

The first two are mostly determined by the Fed, whereas the third is impacted by policy actions taken by the President and Congress. So let’s think about the question:

Why isn’t the economy worse?

What is “the economy”? If the question is why aren’t inflation and unemployment doing much worse, the answer is “good Fed policy.” If the question is why isn’t long run real GDP doing much worse, then we need to ask two questions. What would it mean for real growth to be much worse? And how do we know that it is not becoming much worse?

In my view, a 1% drop in real GDP trend growth (from roughly 2%/year to roughly 1%/year) would constitute “much worse”. It would lower living standards by roughly 20% over a 20 year period. Has such a growth slowdown begun? Clearly it is too soon to say. FWIW, growth ran at a 1.2% annual rate during the first 6 months of 2025.

But I wouldn’t put much weight on 6 months of GDP growth. Even though I strongly dislike Trump’s tariff policy, I would not expect the policy to reduce long run growth by anywhere near 1%/year. There is a great deal of ruin in a nation. Lower immigration might have a bigger impact. (NGDP rose at a 4.1% annual rate in the first half, which is close to optimal unless the workforce shrinks due to deportations.)

Much of the media, and even many economists, wrongly believe that inflation and the business cycle are driven by real shocks. That flawed model of the economy leads to a great deal of head-scratching when things don’t play out as expected. Here’s a headline and subhead from The Economist:

War, geopolitics, energy crisis: how the economy evades every disaster

A new form of capitalism may explain its success

This reminds me of the so-called “Great Moderation”. During the Greenspan era, pundits pointed to irrelevant factors such as the internet and Chinese imports when explaining the persistently low inflation of the 1990s and 2000s. In fact, there was no mystery to be explained; you’d expect low inflation when the Fed keeps NGDP growth fairly moderate, and you’d expect high inflation when the Fed creates rapid NGDP growth (such as during 1966-81 and 2021-22.)

Perhaps something has changed. Mr Ahir and his colleagues present evidence suggesting so. Since 1990 uncertainty has hurt growth less than before. Recent developments hint at further progress. . . .

The emergence of a new form of capitalism, which could be called “the teflon economy”, may be behind these shifts. On one side of the equation, firms are better than ever at dealing with shocks, meaning markets continue to function even at a time when politics breaks down. On the other side, governments offer their economies unprecedented levels of protection.

I understand that catchy phrases like “a new form of capitalism” are much more exciting than, “the Fed is generating stable NGDP growth”, so I guess I cannot blame reporters for writing this way. More discouraging is the way that so many economists ignore Fed policy when trying to explain movements in inflation and the business cycle.

In fairness, the final sentence in the quote above does hint at the key factor, if we interpret “unprecedented levels of protection” as monetary policy leading to stable NGDP growth. And the following paragraph is excellent:

Start with supply chains. The conventional narrative that they are prone to “failure” is largely wrong. During the pandemic some commodities became a lot more expensive—but this was a consequence of an enormous surge in demand, rather than falling supply. Semiconductors are a classic example. In 2021 chipmakers shipped 1.2trn units, some 15% more than the year before. The industry did not really suffer a “supply crunch”. Rather, it responded well to an extreme surge in demand.

The Economist article has an interesting graph (produced by Goldman Sachs), which nicely illustrates the way that pundits tend to overreact to policy-related news:

Pundits argue that risk of a Taiwan invasion has recently increased sharply. Market indicators provide no evidence that the risk has increased. (To be sure, risk is steady at a worrisomely high level.) I suspect that the red line reflects growing anti-Chinese attitudes in government and the media, not actual “news.”

BTW, the Financial Times has a new editorial entitled:

China’s battle with deflation isn’t just a demand problem

Actually it is. Not all deflation is produced by falling demand, but all deflation that is worth “battling” is a demand problem. Supply-side inflation deflation is a good thing, and ought not be battled. Read Less Than Zero.

China does have overcapacity in certain industries, but that’s not what causes deflation of the overall price level. Sectoral imbalances cause relative price changes.

PS. When I asked ChatGPT for the official Q2 nominal GDP growth rate it said that it did not know, and suggested that real GDP figures are easier to find. Sigh . . .

PPS. Catch the mistake in Matt Darling’s tweet.