opinion | How a recession could happen – and maybe not –
The US economy is still very strong, with initial claims for unemployment insurance, for example, at their lowest level since 1969. However, everyone is talking about a recession. The truth is that there is a high chance of a recession over the next few years. But do people understand why?
Part of the answer is that there is Always The chance of a recession in the near future, no matter what the current data looks like. Since bumper stickers don’t quite say, things happen. There is always a chance, for example, of a financial crisis few anticipate or a war that disrupts global trade.
However, our current situation clearly creates a high risk of recession, mainly because policy makers – and essentially, in practice, the Federal Reserve – are trying to steer a course by facing risks. They can do it – in fact, I think they will. But they may not. And here’s the thing: The kind of recession we’re going through, if we have one, will depend on how the Fed goes wrong.
where are we now? Inflation, of course, is unacceptably high. It reflects some of this upheaval – supply chain problems, rising food and energy prices due to the war in Ukraine – that is likely to fade over time. In fact, I would argue that these temporary factors account for the majority of inflation, which is why nearly every major economy is experiencing its highest inflation in decades.
But inflation, which was previously restricted to a few sectors severely affected by the epidemic, has widened. So I find myself in reluctant agreement with economists asserting that the US economy is overheating – that aggregate demand exceeds production capacity and that the two need to align.
The good news is that there is no substantial evidence that inflation has become entrenched – we are in the situation we were in around 1980, when inflation continued just because everyone expected it to. Every metric I can find shows that people expect high inflation for the next year but much lower inflation over the medium term, indicating that Americans still view low inflation as the norm. Here, for example, are the results of the New York Federal Reserve’s survey of consumer expectations:
Aside: I wish people would stop talking about the “wage-price spiral”. Such a vortex is supposed to occur when workers demand higher wages because they believe they deserve compensation for the higher cost of living. Ask yourself: Does this look like the America we live in today? Who exactly are these workers who are demanding what they think they deserve? We have become a country where workers take what they can get, and employers pay what they must. In such a country the whole spiral of wage-price narrative makes no sense.
But let’s go back to the current situation. The fact that inflation has not yet taken hold offers the possibility of an easy downturn. I will schematically show where we are and what should happen like this:
In the figure, potential GDP is the level of output consistent with the acceptable rate of inflation – a level that grows over time. I agree – grudgingly, as I said – that we are currently above that level. But we can close that gap without a recession simply by slowing growth, while allowing potential GDP to catch up. As long as inflation is not rooted in expectations and temporary disturbances have faded, closing the gap should bring inflation down to an acceptable rate.
Why do I call this the “moderate path”? Because, as the following figure shows, a policy can err in either direction:
One possibility, which has been the subject of many, many yells from inflation hawks, is that the Fed is moving too slowly, and the economy is going to heat up for a long time — the red track in the figure — and that inflation will become entrenched. At this point, lowering the rate of inflation would require putting the economy into trouble, as Paul Volcker did in the 1980s, when it took years of extremely high unemployment to undo the inflationary legacy of the 1970s. This means that insufficient tightening by the Fed would set the stage for a bad slump below the pike.
But there is another possibility, which, if you ask me, is not getting enough attention. That is, the Fed will move, or may already have moved, too quickly and the economy will cool down too much. In this case – as can be seen from the blue path in the figure – we may have an unnecessary stagnation, which can develop very quickly.
Why worry about this possibility? After all, so far the Fed has done little in the way of concrete action: it raised the interest rate it controls by only a quarter of a percentage point. But long-term interest rates that matter to the real economy, especially mortgage rates, have already gone up on the expectation that there will be more rate increases in the future:
Practically speaking then, the Fed has already done a lot to calm the economy. Have I done enough? Did you do a lot? It’s really hard to say.
After all, there’s a reason I used schematic numbers rather than real numbers to present my argument in today’s newsletter. Most, but not all, macroeconomists seem to agree that the economy is at least somewhat overheated. But there is no consensus on the amount. We also don’t really know how much higher interest rates will slow the economy. These uncertainties are making the Fed’s job really difficult right now.
What we do know, or at least what I will discuss, is that there is a way through this difficult moment that does not need a recession. And while the Fed can err – and certainly will to some extent, because these are tough times – it can err either way. Right now, I’m concerned that the Fed is overreacting to inflation. But time will tell.