Changes to Our Forecast: Reasons Behind Our Decision

Chief Economist Eugenio J. Alemán discusses current economic conditions.

Last week we changed our economic forecast because the economy has remained stronger than we expected. We delayed the start of the recession to the first quarter of 2024 rather than the last quarter of 2023. There were several reasons for the change. First, employment has remained stronger than what we had expected, and it is unlikely to weaken enough over the next few months, therefore making it improbable that a recession will start during the last quarter of the year.

Second, the administration’s passage of several bills last year, including the Inflation Reduction Act (IRA), the CHIPS Act, and the Infrastructure bill, have contributed to a stronger investment profile than what would have been expected with such a strong increase in interest rates over the last year and a half. That is, although the increase in interest rates has had an important negative effect on residential investment, nonresidential investment has continued to perform well because of the added stimulus brought about by these bills. Furthermore, according to new research by the Chicago Federal Reserve (Fed), the responsiveness of monetary policy on investment has been “delayed,” they argue, because the profile of investment has changed considerably over the years, from mostly investments in tangible assets, which react faster to monetary policy decisions, to increased investment in what is called “intangible” investments, that is investments in assets such as intellectual property or software.1

Gross Private Domestic Investment and the Fed Funds Rate

In the graph above, we have plotted the federal funds rate and overall real investment at the top and then below we split real investment into real residential investment and real nonresidential investment. Also, recall that nonresidential investment is about two-thirds of total real investment spending while residential investment is the remaining one-third. The graph shows the strong negative effects of higher interest rates on real residential investment but almost no effects on nonresidential investment. Furthermore, as the graph clearly shows, today’s scenario is eerily similar to what happened back in 1994-1995 when the Fed engineered what some call a ‘soft landing.’