By Daniel Coats ’15, ’18
A lot can change in a span of 18 months. At the start of 2021, as the economy was emerging from the pandemic, some economists and policymakers anticipated a steady expansion with only transitory inflation due to supply chain bottlenecks. As predicted by Cal State Fullerton’s economists, however, inflation has proven to be stubborn and a longer-term headwind. The debate is now over whether the economy will fall into an outright recession or whether a stagflation scenario – stagnant growth and high inflation – will play out.
Cal State Fullerton’s expert economists, Anil Puri and Mira Farka, provided their perspective at the 28th Annual Economic Forecast Conference, held at the Disneyland Hotel on Oct. 27. The two anticipate a looming recession but not an extreme downturn as witnessed during COVID’s early days or during the Great Recession of 2007-2009.
“There are three main reasons why a soft-landing scenario is now out of reach and a recession the most likely outcome,” argue Puri and Farka in their report. “First, the timing of rate hikes. It matters greatly whether the tightening occurs into a dynamic growing economy – as was the case last year – or in an environment where growth is cooling – as is the case now. The second factor is related to the pace of monetary firming. Having changed tack too late, the Fed is trying to avoid at all costs doing too little, especially early in the cycle. It has tightened monetary policy more sharply than at any time since 1980. The third reason why a soft-landing appears out of reach has to do with the mix of monetary and fiscal policies. To successfully slay inflation, monetary and fiscal policies have to work in tandem to wring excesses out of the system. The opposite is happening now: Even as monetary policy turns restrictive, spendthrift governments have yet to follow suit.”
Contradictory Data Clouds the Outlook
The first two quarters of 2022 saw negative economic growth. That matches the lay definition of an economic recession. But with historically low unemployment rates and the addition of 3.8 million jobs in the first nine months of 2022, the situation this time around is a lot more nuanced.
On the negative side, a declining stock market (including the worst half-year performance since 1970), depressed consumer confidence and lowered business sentiment portend trouble ahead.
There is “the bone-chilling realization that the path of [this expansion] is beset on all sides by the inequities of [past excesses] and the tyranny of [powerful headwinds]. Risks have never been this high. Wherever you look, gloomy projections are scrapped and replaced with even gloomier ones,” say Puri and Farka.
As an example, Farka points to the Federal Reserve’s early estimate of 2.8% growth in 2022 and 2.2% growth in 2023. As we near the end of the year, the forecast is now for 0.2% growth in 2022 and 1.2% in 2023.
The federal funds rate – the interest rate that underpins all other interest rates in the economy, including what consumers pay – is now expected to be at 4.4% at the end of this year and 4.6% at the end of 2023. Though relatively modest rates historically, that is far above the perennially close to zero interest rates that have prevailed for most of the new millennium.
Internationally, the energy crisis in Europe, exacerbated by Russia’s war in Ukraine, China’s stubborn zero COVID policy that has kept lockdowns in place in the world’s most populous country even as most of the rest of the world says goodbye to the pandemic, and the synchronized increases in interest rates by central banks globally to fight inflation have combined for a dramatic rise in risks in the global economy.
With all the uncertainty, Puri and Farka maintain that there are two likely outcomes: “In the first scenario, we predict a short recession, but one that cuts significantly deeper than what the market expects, where inflation is brought to heel but at an exorbitant cost of uncomfortably high unemployment and considerable financial instability. In the second scenario, the recession is milder, but the economy is marred in the doldrums of a lengthy period of below-trend growth and above-trend inflation, a stagflation-like environment.”
In either case, inflation underpins the outlook, as well as the resilience of the U.S. economy, which has made it unlikely that the Fed will quickly revert course and let up on its interest rate-hiking crusade.
There is a bit of good news: A global financial crisis akin to 2008 seems unlikely – at least at the moment.
“Consumer and bank balance sheets are much healthier this time around than before the Great Recession, which means stress is unlikely to come from these sectors,” report the economists. “However, the darker corners of the shadow banking systems – a chaotic amalgam of nonbank financial entities — are poorly regulated and even more poorly understood.”
The recent turmoil in British bond markets and concerns about Swiss bank Credit Suisse provide reason for caution in the outlook for the financial sector.
Will the Fed Relent?
The Fed’s 2% target for inflation – historically consistent with price stability– would require a sustained period of interest rate increases well above the Fed’s current baseline of 4.6% for next year. That would mean the economy would fall into a deep recession, with the jobless rate rising to 7.5% – and staying there for two years at least.
Fiscal policy – such as the scaled-down version of the Build Back Better agenda passed in August and debt relief for college alumni with student debt – are sure to contribute to inflation, making the Fed’s job even harder.
“Our view is that the Fed will ultimately back off from its ‘unconditional’ fight to slay inflation after winning some battles but without winning the war,” predict Puri and Farka. “As rate hikes bite and the energy crisis abates to a certain extent, inflation rates will come down from today’s dizzying rate. But they are likely to settle at a higher rate than the Fed’s 2% target, at least for as long as government support continues to roll in and excess cash remains above normal levels. While inflation rates above 8% are intolerable, a 4%-5% range is more politically bearable if it saves millions of jobs in the process. Thus, we expect the federal funds rate to crest at the 5%-5.25% range early next year and remain at that level until the end of 2023. This would imply a shallower U.S. recession, but one that is marred by stagflationary dynamics.”
So perhaps we all will need to learn to live with higher prices – in the medium if not long term.
The Dashboard: What To Expect Over the Next Three Years
| VARIABLE | 2022 | 2023 | 2024 | 2022-2024 Avg. |
| U.S. Real GDP Growth Rate | 1.7% | -0.7% | 0.3% | 0.4% |
| U.S. Unemployment Rate | 3.6% | 4.8% | 5.4% | 4.6% |
| Consumer Price Index (CPI) Change | 8.2% | 5.5% | 4.4% | 6.0% |
| Personal Income Change | 2.3% | 2.1% | 2.8% | 2.4% |
| 30-Year Fixed Mortgage Rate | 7.27% | 7.32% | 5.87% | 6.82% |
| Oil Prices (Dollars Per Barrell) | $102.1 | $85.2 | $78.3 | $88.5 |
The Orange County View
Much as in the nation as a whole, Southern California and Orange County have experienced a mixed and twisted recovery from the pandemic. Most significantly, Los Angeles and Orange counties have yet to fully recover the jobs lost during the pandemic; however, the Inland Empire has experienced a full recovery. And the recession and stagflation dynamics anticipated across the nation also are forecast to impact the Southland.
Southern California has seen some welcome very low unemployment rates, dipping as low as 2.4% in Orange County.
“In addition to a large number of people retiring, those who stepped out of the labor force during the last two years appear to be slow in returning to work, leading to very tight labor markets,” explain Puri and Farka. “This national phenomenon is very much in play in the local economies. Employers continue to scramble to keep their current workforce and have offered bonuses, wage increases, flexible hours and other accommodations.”
As usual, housing is front-and-center for the Southern California outlook. Since the shutdowns of March 2020, home prices have increased dramatically in the region, with Orange County reaching a staggering $1.136 million median single-family home price in August 2022. Even median prices in San Bernardino County – the most affordable in the region – have reached $487,000.
“Pent-up housing demand following the pandemic is only a part of the explanation for this price spike,” say Puri and Farka. “Sure, the pandemic caused an increase in housing demand as people began working from home, thus needing more space. Low interest rates during the past several years and excess cash generated by pandemic-induced government support further inflamed an already hot market. But a lot of this has to do with the supply-side: A shortage of new housing and a meager inventory of existing homes have further fueled the flames.”
Looking ahead, rising mortgage rates, unaffordability of housing and weakened demand will weigh heavily on the housing sector, likely causing a 10% to 15% decline in the region’s home prices, according to the Puri and Farka forecast.
The Cal State Fullerton Orange County Business Expectations (OCBX) survey, which asks Orange County business professionals what they anticipate in the near-term, reveals a slight increase to 63.9, a value that indicates anticipated continued expansion. Over two-thirds of business leaders see inflation as their most important concern. But there is division on whether a recession is on the horizon. 42% of respondents don’t see one in the next two years, but 9.6% think it’s already here. 48% expect a recession to begin, either by the end of 2022 or during 2023.
Though focused on the next three years, Puri and Farka also noted major long-term trend changes in the California outlook relating to population increases.
Despite nearly two centuries of steady growth, the Golden State has seen declines in population for the first time in recent years, due to domestic migration out of state. Immigration and birth rates are also much lower than in the past.
“Slower or negative population growth and the changing age profile of the population raise significant questions about the nature of future economic growth in the county,” say Puri and Farka. “These developments may not have much of an impact in the near term, but they are important issues that require a more active public policy approach and a more prominent focus in policy-making decisions.”
With changing employment structures – less manufacturing and more health care, technology and services – and stagnant population growth, Orange County, California and much of the nation are changing slowly but surely.
Read the full report at the Woods Center for Economic Analysis and Forecasting website.