The outlook for the economy has improved. And yet. (2023)

It's not easy to say it out loud.

As Federal Reserve policymakers head to the annual summer conclave in Jackson Hole, Wyoming, the state of the US economy and markets looks awfully good.

I am not at all sure that this calm attitude will last. However, before discussing some reasons for my anxiety, it's time to present some positives.

The stock market is still down from its 2022 peak, but getting close. Inflation is much less severe than a year ago, the economy is still incredibly strong and unemployment is thankfully low. It is even possible that the Federal Reserve will succeed in taking the economy to an unlikely place: a fairly painless soft landing, despite steep interest rate hikes.

But I've been anticipating trouble for a long time, ever since inflation started to skyrocket and the Federal Reserve launched a monetary tightening campaign more than a year and a half ago.

So enjoy the tranquility of summer, but it may still be too early to fully relax.

After all, the effects of monetary policy are "long and variable delays," HowMilton Friedman, a great monetarist, as Jerome H. Powell, Chairman of the Federal Reserve, often remarks today. In this interest rate cycle, the Federal Reserve has already raised its short-term Fed Funds rate by as much as 5 percentage points (500 basis points, in bond market parlance). At some point, when interest rates get this high, economic growth tends to slow down.

There's an old saying: The Federal Reserve raises interest rates until something goes wrong. Yes, there have been a series of bank failures, but the impact on the wider economy has been small so far. In the end, the Federal Reserve hasn't broken much yet.

In fact, despite the rise in interest rates inmortgagesand credit cards,construction of a residential housejconsumer spendingthey are still surprisingly strong. That's good news, but things shouldn't work that way. In Jackson Hole and elsewhere, the Federal Reserve and other central banks will review their assumptions about how monetary policy actually works.

What we're seeing in the U.S. economy is a pleasant surprise, but one that requires careful scrutiny, says Adam Posen, president of the Peterson Institute for International Economics in Washington, D.C. and a former member of the Bank of England's interest-setting division. group. Politics, he said at a press conference last week.

What is surprising about this strange calm in the economy is that the Federal Reserve is putting a brake on growth by raising interest rates and reducing its funds.balance(a policy known as quantitative tightening) at an extremely sensitive time.

The US economy is still feeling, if not affected, the job and supply shocks caused by the pandemic and the commodity shortages caused by Russia's war with Ukraine. Hethe price of wheatit fluctuated. Oil prices rose again, partly due to restrictions on Russian oil and partly due to voluntary measures.production cutsof Saudi Arabia and other members of the OPEC Plus consortium to increase profits from fossil fuels.

Apart from,China's slowdownThis has implications for the global economy. Still a plus thoughfalling pricesIt can be expected to contribute, albeit marginally, to disinflation in the United States and other parts of the world.

In addition, the political polarization in the United States is beginning to eclipse the country's financial splendour. This isthe core of the messageThe rating downgrade of US Treasuries this month by Fitch Ratings.

The United States was close byinfringementin May he paid off his debt, not because the government couldn't raise the money he needed, but because Congress would only allow it at the last minute. And when Congress meets again in September, it will have just a few weeks to agree on a federal budget before the Sept. 30 deadline. My colleague,Karol Hulseassessed this mild outcome as highly unlikely. While the leaders of the House and Senate dodiscussedIf there is an interim spending deal, a new government shutdown could be in jeopardy in the event of a deadlock.

At the same time, the prospect of the pre-presidential election campaign, with aaccusedthe fact that the former president is one of the leading candidates is disturbing, to say the least. It would not be surprising if the stock and bond markets reacted extremely negatively when political tensions rise again, which is almost certain to happen.

Still, the economy is resilient and stable, and markets have come a long way since the crisisgloomy days in early 2022As inflation soared, the Federal Reserve began aggressively raising interest rates, the stock market got off to its worst start in years, and…Russian troopstook place in Ukraine.

This year, however, the stock market grew so fast (and until July in such a limited way, with growth driven by a handful of giant tech companies) that it seemed to be heading into unsustainable and irrationally exuberant territory. In July, however, earnings began to deepen and the relentless rise in inventories slowed. It is therefore reasonable to assume that the danger of an unsustainable “crash” leading to another market crash may have disappeared for the time being.

Edward Yardeni,An independent Wall Street economist is generally optimistic about the market outlook, but says some concerns may be warranted. In a recent note to clients, he outlined two different stock market strategies. The first was pretty bullish. He called it "Don't worry, be happy". It's impossible for me. The second, which I liked more, was entitled "Worry, but be happy anyway."

He cited many reasons for concern. Think of the crisis in the commercial real estate sector; possible signs of an incipient wage and price spiral that could complicate the Federal Reserve's fight against inflation; skepticism about the fight against inflation in the bond market; and the possibility of inflation rising again, forcing the Federal Reserve to raise interest rates further and plunging the economy into recession.

Blue Chip Economic Indicators, a long-running monthly survey of economists published by Wolters Kluwer, "estimates a 50% chance of a recession in the next 12 months, though that figure is down from 56% last month."

I can't accurately predict a recession, and no one else can. However, despite a strong labor market and good recent economic reports, I believe a recession is real next year.

So at the end of the summer, my overall investment outlook will remain unchanged. It is based on ignorance of the immediate future, but on certainty of the long-term future. Serious investors have always had to stay there for decades and keep stocks and bonds in a mix that suits their personal risk tolerance. This risk can be mitigated primarily by using low-cost index funds that reflect all global markets.

But there are no guarantees, and as experience shows that accidents happen regularly, it is also important to be prepared for any eventuality and to have enough cash on hand to pay your bills.

I admit that saying the glass is half full might be more reasonable at this point than saying it's half empty. Unfortunately, I'm not sure, and the economists and Federal Reserve officials aren't meeting in Jackson Hole either.