- Fixed Income Portfolio Manager
United States, Institutional
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”Don’t be fooled by the rocks that I got, I’m still Jenny from the block.” – Jennifer Lopez
It seems that not a day goes by without economists commenting on the resilience of the US economy in the face of higher interest rates. This line of thinking has permeated the Federal Reserve (Fed), with many regional Fed presidents claiming that the neutral rate, at which monetary policy is neither restrictive nor expansionary, is higher than it was pre-COVID. But is it? With most of the data for the fourth quarter of 2023 now in, it is worth looking at the current state of inflation, employment, growth, productivity, and debt compared to their pre-COVID levels to see what, if anything, is truly different.
Inflation, unemployment, growth, and productivity
One of the biggest changes caused by COVID economic policies was the high level of inflation, which reached levels in mid-2022 not seen since the 1970s. The effect of restrictive monetary policy needed to tame inflation, however, along with healing supply curves amid the rebound in manufacturing and trade, have dealt inflation a serious blow since then — January’s mini-spike in CPI notwithstanding. For the six months ending in January 2024, the annualized level of the core Personal Consumption Expenditure (PCE) Index, the Fed’s preferred inflation measure, was 2.5%. While this is certainly higher than the six-month annualized rate of 1.3% in December 2019, it is rapidly converging to the Fed’s long-term 2% inflation target.
We can break core inflation down to its three components: goods, shelter, and services. As a group, core goods is now in deflationary territory, a bit lower than in 2019. The healing of supply chains and the consumption hangover from robust goods purchases during the lockdowns are the culprits. Shelter inflation is still running very high, notching a 6.2% increase in 2023. Given elevated rental inventory in many parts of the US, it is reasonable to assume that shelter inflation growth will slow substantially this year, at a rate much closer to its long-term average of 2% – 3%. However, core services inflation has remained relatively high, owing to the tight labor market.
This brings us to unemployment, the second pillar of the Fed’s dual mandate. As of this writing, the US unemployment rate is currently at 3.9%; again, not far off from the 3.6% rate at the end of 2019. The six-month annualized growth in total private payrolls is 1.6%, close to what it was in 2019, at 1.3%. In other words, the labor market tightness is not substantially different than it was pre-COVID. In addition, a few forward indicators of wage growth have declined markedly over the past year. For example, the so-called “quits rate,” the percentage of workers who voluntarily leave their jobs, has come down substantially and is currently at 2.1%, compared to 2.3% in December 2019, consistent with wage growth at pre-COVID levels. Given the relatively steady state of US employment, we should expect that core services inflation, which was sticky throughout 2023, may also fall back to levels consistent with the Fed’s inflation target.
While not part of the Fed’s mandate, growth unquestionably exceeded expectations in 2023 at 3.1%. However, pulling back the lens a bit, over a longer time horizon, the real (inflation-adjusted) growth rate is not drastically different today than it was before COVID. For the four years ending in December 2023 (which includes the pandemic), annualized real growth in the US was 2.0%, which is below the prior four-year period, when growth annualized at 2.6%.
How about productivity? During the most recent four-year period, nonfarm productivity grew at a 1.6% annualized pace, below the 1.8% rate for the prior four-year period. Many economists, and evidently US stock market participants, believe that AI will dramatically increase worker productivity. Higher productivity leads to higher real growth, and therefore, higher neutral rates. These are, of course, extremely early days for AI, and the effect on productivity is not certain. As the late Robert Solow, a Nobel laureate US economist, said of the computer revolution in 1987, “You can see the computer age everywhere but in the productivity statistics.” While AI might eventually be transformative for the economy, we have yet to see companies, in aggregate, increase capital expenditures at a substantially higher rate than they had pre-COVID.
What is different about the economy today? Debt.
One economic metric that is substantially different than it was pre-COVID is government debt. At the end of the third quarter of 2023, combined US federal, state, and local government debt as a percentage of GDP was 117%, compared to 101% at the end of 2019. That figure does reflect a decline from a peak of 130% in the second quarter of 2020, when government leverage was employed to prop up the economy in the throes of pandemic lockdowns.
This deleveraging has not occurred because of fiscal restraint, strong real growth, or higher tax revenues; rather, nominal GDP has risen substantially because of inflation. In addition, the Fed held interest rates much lower than the level of inflation immediately following the pandemic. Why? While we can debate whether the economy can handle higher real rates, I maintain that the government does not want them. The Congressional Budget Office estimates that if interest rates stay at current levels, federal debt will rise by nearly 17% of GDP over the next 10 years, eclipsing the highs during COVID.
As I have written in previous pieces, fiscal spending goes directly to companies’ bottom lines. The most recent fiscal-induced profit surge has driven equity prices higher, boosting the wealth effect for many US households. As a result, consumers have been able to keep spending on services, enabling the economy to continue growing above potential. This dynamic has muted the effects of higher rates. However, as the largely unchanged figures of inflation, unemployment, and growth show, the economic picture is not drastically different than it was pre-COVID. If government spending slows, we might find out that the neutral rate is not that different either. Like J. Lo’s many diamonds, the US economy has new “rocks” (in the form of a fiscal-induced increase in net worth), but it might be the same old Jenny from the block.
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Monthly Market Review — October 2025
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