December 4, 2022

How 10 Economists Think About the Economy Potentially Overheating

I think there is a fair amount of consensus that the economy will grow strongly beginning in the fourth quarter of 2021 and that inflation will rise. I also believe, although there is less consensus here, that the level of economic activity will temporarily rise above its sustainable level for a time and inflation will rise above the Fed’s target. If you want to call that overheating, I think that isn’t in and of itself problematic. In fact, I think making up for some lost economic activity is beneficial. And, the Fed has said it welcomes a rebound in inflation.

So where would I be concerned? Is this just a matter of degrees? In isolation, there isn’t a credible prediction of temporary overheating or inflationary pressure that worries me. For example, I think we can increase labor force participation well above its sustainable level for several quarters. Same with capacity utilization. I don’t think anyone will be too surprised to see massive airfare inflation. Instead, I worry if we start to see signs that people, businesses and financial markets are responding to the level of overheating as if it were permanent. On one dimension, that could suggest a harder landing. For example — I would worry about a significant jump in the quit rate.

I would worry about a housing construction boom or a commercial real estate boom. I would worry about a significant increase in leverage across the economy. That all suggests pain for people when the economy cools. On another dimension, if financial markets start to view the overheating as being too permanent, we could see inflation expectation rise to worrying levels — well above the Fed’s target. For example, I think we need to keep a close eye on the five-year, five-year forward inflation expectation rate. The Cleveland Fed has a nice roundup of inflation expectation measures.

I would worry about the Fed’s credibility if longer-term expectations remained stubbornly above where they were in 2019 by, say, one-half percentage point. Which is to say, the economy has benefited from the Fed being credible about its policy direction. If it’s lost, regaining that credibility would exact a toll. Still, everything I see in terms of underlying economic strength, households’ resources, and the fiscal support in train points to a several-quarter-long surge in the economy. We — policymakers, households, businesses — need to appreciate its temporary nature and adjust accordingly.

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