US economy may be heading to a place that must not be named

Back in the late 1970s, when economist Alfred Kahn was the Carter administration’s “inflation czar,” he got into political trouble for describing economic declines with clear and disturbing words like “depression” and “recession.” (I always think of him as Professor Kahn, because he was a dean at Cornell in the early 1970s, just before he entered the world of public policy. He frequently told us, above all else, to use plain and simple English.)

When Kahn left Cornell for government posts, he became renowned for those precepts, attacking “the artificial and hyper-legal language that is sometimes known as bureaucratese or gobbledygook.” Those words come from a memo he wrote to his staff at the Civil Aeronautics Board in 1977. The Washington Post published the whole thing. Please, he told government employees, use “straightforward, quasi-conversational, humane prose — as though you are talking to or communicating with real people.”

By 1978, however, as inflation czar, Kahn had found that the rules of simple, clear language just didn’t apply to high-level presidential appointees dealing with potential economic downturns.

Recession? Too scary. Depression? Even worse. Political operatives within the Carter administration chastised him for saying those words out loud. So he found a better, Marxian term — one fit for Groucho, not Karl. Henceforth, he said, economic downturns were “bananas,” as in this sentence: “Between 1973 and 1975 we had the deepest banana that we had in 35 years, and yet inflation dipped only very briefly.”

When the banana lobby protested, he began to talk of a coming “kumquat.”

Well, we may be facing a banana or a kumquat, of indeterminate size, very soon.

Soft and Hard Landings

Jerome Powell, the Fed chair, has focused mainly on battling inflation for more than a year. Until last month, he had been saying the Fed could raise interest rates and pare its swollen balance sheet without wreaking too much harm. This approach works by slowing the economy and cooling the labor market.

The United States, he had said, could have what he called a pleasant and soft landing.

But in March, he said that benign outcome was less likely as a result of tightening conditions caused by bank failures. The emergency rescue operations by the Fed, the Federal Deposit Insurance Corp. and other regulators ensured that depositors had access to their money. Financial markets calmed down.

The banking crisis has added to the risk that real trouble may be ahead of us. Typically when financial conditions tighten a lot, millions of people are thrown out of work. If such a downturn is prolonged and protracted, months after the fact it is labeled a recession.

Still, the banking troubles have improved the chances that inflation can be tamed without the need for too many more Fed interest rate increases. The Fed’s financial tightening has already created greater stress in the financial system — stress that, so far, has emerged in the form of the failures of Silicon Valley Bank and Signature Bank and troubles in other institutions, including First Republic.

The economy looks fairly strong. The unemployment rate in March was just 3.5%, though job growth slowed. Futures prices show that investors can’t make up their minds about what will happen next. The probability of a rate increase in May, at the next Fed policymaking meeting, has been veering up and down.

There is evidence of inconsistency in the Fed’s own forecasts, as Tim Duy, a University of Oregon economics professor and chief U.S. economist for SGH Macro Advisors, has pointed out in notes to clients.

On March 27, he observed that the Fed’s “growth forecast of just 0.4% for the year implicitly includes a sudden stop in the economy, assuming activity rebounded in the first quarter as GDP tracking indicators suggest.” Indeed, the real-time GDP estimate produced by the Federal Reserve Bank of Atlanta shows the economy growing in the first three months of the year at an annualized rate of about 1.5%.

The Fed doesn’t spell this out. But for growth for the full year to fall to 0.4%, as the Fed predicts, the economy would need to shrink rapidly in the next six months or so. Financial tightening — whether brought about by interest rate increases, bank failures, the reduction of assets on the Fed’s balance sheet or a combination of them — works slowly on the broader economy. Its precise effects can’t be accurately predicted, so we are in an awkward period.

Whether the slowdown engineered by the Fed will be justifiably called a soft landing — a slowdown that won’t be remembered as a particularly devastating downturn in years to come — or a crash that really hurts millions of people is a crucial question.

“A sudden stop in the economy sufficient to drive a large increase in the unemployment rate will almost surely have enough momentum to shift the Fed’s concerns away from inflation and back to employment,” Duy wrote. “Clearly, the Fed would see a sufficiently weak labor market as a disinflationary event.”

If a big slowdown comes, the Fed will have to pivot and cut interest rates. But we just don’t know right now.

The Implications

How this plays out will affect many vital things: whether some of us keep our jobs, whether price increases moderate and whether the prices of stocks, bonds and real estate rise or fall. No one has clear answers.

Certainly, the markets, which represent the collective wisdom of investors, have not done a particularly good job of forecasting the state of the economy over the last year.

The latest data from Morningstar on mutual fund and exchange-traded fund performance bear this out. Investors have been befuddled by economic trends.

In the 12 months through March, the average stock fund lost 8.3%, while the average taxable bond fund lost 3.6%. That was a terrible year. In the first three months of this year — mainly, before the bank crisis — investors did much better. The average stock fund rose 5.4%, while the average taxable bond fund returned 2.6%.

What is striking about these results is that there is no consistency from year to year. The funds that did best in the first quarter of 2023 tended to be among the worst for the last 12 months. The Virtus Zevenbergen Innovative Growth Stock Fund, for example, gained 28.4% in the quarter, a spectacular result. But for the 12 months through March, it lost 32.1%. The underlying stocks in the portfolio — including Tesla, Amazon and Nvidia — had Jekyll and Hyde performances, too, depending on which month you looked at them.

Similarly, the performance of bond funds with blue-chip holdings was painfully erratic. The Vanguard Extended Duration Treasury Index fund, for example, contains Treasury bonds. What could be steadier or safer?

Well, bond prices and yields move in opposite directions, and as interest rates rose last year, the fund’s bonds lost value. What’s more, the fund holds 20-or-more-year bonds, which made them particularly vulnerable, because the longer a bond’s duration, the greater the price changes when interest rates move.

In this case, the Vanguard fund gained 6.4% in the first quarter, largely because bond yields fell as traders bet that a recession would be coming soon and that the Fed would be dropping interest rates. But over the 12 months through March, which included a long stretch of interest rate increases, the fund lost 24%. If there is a recession, this will be a good fund to own. If rates rise, though, the fund could lose money again.

Right now, I’d be careful.

I always try to invest for the long term and hold diversified groups of stocks and bonds in low-cost index funds that track the entire market. But I’m also stashing away as much money as I can in safe places.

Fortunately, money market funds are providing good value now. They are paying yields of close to 5% simply because they track the short-term interest rates controlled by the Fed.

If there is a recession and the Fed pivots abruptly, high-quality bonds could be expected to gain in value, while money market rates would fall. The stock market might drop sharply on signs of a major slowdown. But stocks could be expected to rise once the Fed deemed it time to slash rates sharply and strengthen the economy. Trying to time these shifts is treacherous.

The best outcome would no doubt be that often discussed soft landing, accompanied by a decline in the rate of inflation. Jobs would be preserved, and the markets could embark on another bull run.

But be nimble. We could be hurtling toward a banana.

This article originally appeared in The New York Times.

By Jeff Sommer