The economy is moving from growth to contraction, as Thursday’s 0.9% decline in GDP tells us. The debate over whether we are in a recession today is mostly pundits rehearsing their political messages for television, with the November election looming.
We are almost certain to be in recession by year-end or early next year. I’m talking of a real recession, one where companies are laying off workers and the unemployment rate rises from its current unnaturally low levels to somewhere north of 5%. Economic policymakers cannot get inflation down from the current 9% levels without raising interest rates substantially, and as those interest rates work through the economy, spending will decline in many categories, and unemployment will rise. That’s how economies work.
There is a momentum behind inflation, at 9.1% in June, that makes it a challenge to overcome. One company’s price increase is somebody else’s cost increase. Examples of continuing inflationary momentum include the price increases announced this week by two major multinationals: Unilever, producer of household branded products including soaps, Vaseline and Hellman’s Mayonnaise, raised prices an average of 11% in the second quarter. Kimberly-Clark, maker of paper products including Huggies disposable diapers, raised prices 9%. The higher inflation gets, the longer it takes to get it down and purge it from the system, and the more painful are the actions that the Federal Reserve must take to get it down.
The twin causes of our current bout of inflation are the supply side snafus and an excessive stimulus to demand caused by the series of Covid bills culminating in last year’s $1.9 trillion American Rescue Plan (ARP). The two Trump-era Covid support bills and Biden’s ARP provided an injection of $5 trillion of additional spending power into the U.S. economy, an increase worth over 20% of annual GDP. In the words of the New York Times, it was “the largest flood of federal money into the United States economy in recorded history.”
According to one study, the $800 billion Payment Protection Program was shockingly wasteful. For every $1 of federal money that went to an actual worker made unemployed by the Covid shutdown, another $3.13 went to other recipients, typically business owners. Many of those business owners were outright fraudsters, filing for PPP money based on imaginary businesses laying off imaginary workers. In any case, most of those funds were spent quickly on tangible goods and services, creating more demand in the economy. According to one Department of Justice press release, some fraudsters spent their money on “houses, cars, jewelry, and other luxury items.”
The Covid rescue bills put trillions of dollars in the hands of individuals, creating an increase in demand without a corresponding increase in supply. On the contrary, supply was shrinking because, beginning in March 2020, shutdowns in China and elsewhere in Asia restricted supply of goods to the U.S. and global markets. As the various production centers reopened, snafus in the ports and the shipping industry continued to restrict supply. Here at home, as part of a new phenomenon, the “Great Resignation,” workers declined to return to jobs where they felt they were underpaid and underappreciated. This contributed to inflation in sectors like meat and dairy, up 11.7% in the year to June. Chicken is up a shocking 18.6% in the last twelve months.
Inflation is often described as “too much money chasing too few goods.” This is a colloquial paraphrase of the more accurate term “too much demand chasing too little supply.” To fix the problem, and to prevent inflation accelerating further, to the point where it becomes an even bigger problem in the future, the ideal policy solutions would focus on both supply and demand.
Our current inflationary problem was compounded by two further phenomena. The Covid-related downturn of 2020 was not a normal recession but instead a voluntary shutdown of the economy imposed by the federal government at the recommendation of the health authorities. The U.S. shutdown was probably the right thing to do for health reasons, but economists were too quick to call it a “recession.” One quarter later, the economy snapped back: after a downturn of 31.2% in Q2 2020, real GDP rose by 33.8% in Q3. Continued excessive federal spending led to GDP growth of over 6% in three of the four quarters of 2021. This was beyond the economy’s “sustainable” growth rate, as the Congressional Budget Office said. The result was inflation.
The second important phenomenon was the fragility of global supply chains. While these supply chains have enabled multinationals to cut costs over the last 30 years, they increased the risk of disruption. Years of propaganda about the wonder of globalization obscured the fact that production that depends on a disaggregated supply chain and multiple shipping journeys is at far greater risk than a local production process, and one owned by fewer suppliers.
Take automobiles. If production of an American automobile depends on a windshield wiper motor unit that includes a 50 cent microchip that is not made by the motor unit manufacturer, but instead bought from a Texas chipmaker that does not make the chip itself but instead has subcontracted manufacture of that chip to a second-tier Taiwanese chipmaker, and nobody on the automotive side of the business actually knows where that chip is being produced, and Taiwan is suffering supply shortages that restrict chip production, then that automobile may end up sitting in a lot awaiting its wiper motor unit…for months. General Motors reportedly has 95,000 cars sitting in lots awaiting parts. New car inflation is not as bad as used car inflation, simply because consumers can’t buy the new cars. Used car and truck prices in June were 55.6% higher than two years earlier. Despite small price declines in March and April, the June used car and truck index, at 212.98, is at an all-time high. But employment in auto manufacturing is still below 2019 levels.
Why a Recession is Inevitable
Economies move in cycles, like a sine wave. If inflation starts, it can feed on itself and rise rapidly. If a recession starts, the economy can descend for an extended period. We understand how to recover from recession better than we do from inflation. In either case, it is best to tackle the problem early and aggressively and attempt to get the economy back onto its long-term path, which in our case is roughly 2% economic growth and 2% inflation.
Economists who view the business cycle as a critical economic problem in its own right tend to prioritize aggressive solutions. This is because the costs, including human suffering, to fix it later would be higher. Human nature being what it is, people tend to overinvest in the good times and cut back too much in the bad times. We can see this now, for example, in the slumping housing market in Boise, previously one of the hottest “zoomtowns” in the country.
Economists who remember the havoc wreaked by the 1970s inflation tend to prioritize fighting inflation now. The costs of higher inflation will always hit the poor, the casual workers, and minority workers hardest, so it is best to take action early.
An aggressive anti-inflation policy would take action on both the supply and demand side. On the supply side, the Covid-related supply chain problems were followed earlier this year by snafus related to the Russia-Ukraine war, adding further upward pressure to oil, gas, and food prices.
The Democrats’ new Inflation Protection Act offers some new incentives to the domestic oil and gas industry, which could have a moderating effect on energy prices. But it does little else that will have a short-term impact.
The main weapon against inflation is on the demand side, via the federal budget and Federal Reserve monetary policy. The federal budget deficit for the seven months of fiscal 2022 is only $360 billion, down 81% on the corresponding period in fiscal 2021. At this rate, the government will finish the year with a deficit of around $700 billion, the smallest deficit since 2015. The administration is to be praised for prompt action on the budget (and recognizing that this can be done with no need for input from the two warring tribes in Congress).
But the Federal Reserve was slow in recognizing the inflation threat. After being asleep at the switch through much of 2021, they are raising interest rates aggressively this year. Wednesday’s move brings the key Federal Funds up to 2.25%-2.50%, its highest level since 2008. The rate will probably reach 4% by the end of the year.
Consumers have already reacted to skyrocketing food and fuel prices by cutting back on nonessential spending—just at the moment when companies were building up inventories after the Covid shortages. Higher interest rates will add new downward pressure on the economy through multiple channels. Businesses will cut back on investment because of a higher cost of borrowing. On the consumer side, house prices and house sales will decline. This is already evident, with single-family home sales in June down 8.1% from May and down 17.4% from June last year. The decline in home sales will feed through to purchases of home improvement tools and supplies at Home Depot and similar retailers. Weber Grill, a $2 billion maker of outdoor grills, fired its CEO earlier this week, only 11 months after going public. The company cited supply chain pressures and weak consumer sales as contributing factors. Weber makes much of its product line in China.
The markets continue to doubt that the Fed will act aggressively enough to reverse inflation. Former Fed governor Randal Quarles recently criticized the Fed for not being bold enough in raising rates soon enough. Respected bond fund manager Mohamed El Arian has made similar comments, suggesting the Fed has recently been prone to “fairy-tale economics” and needs to discard its soft-on-inflation 2020 analytical framework in favor of a new approach.
Former Treasury Secretary Larry Summers has argued that recession is coming, because history shows that whenever inflation has been above 8% and unemployment below 5%, the tightening necessary to get inflation under control has been sufficient to put the economy into recession.
Summers is right about that. We are entering a new world, one where deflationary price reductions from Asia are no longer sufficient to keep inflation in check. That means monetary policy must be more restrictive than it has been in the last 17 years. We need to achieve real positive short-term interest rates, in other words get interest rates a couple of points above the inflation rate. So we may get next year to a position where inflation is at or close to 4% and short term interest rates are in the 6%-7% range.
Summers is a good macroeconomist. But he is a terrible strategic or growth economist. He wants to remove tariffs, which would be a counterproductive move. It would have zero effect on inflation and it would simply reinforce the pressures of imports on our economy. The strong dollar will bring in more imports, hurting our manufacturing sector yet again over the next 24 months. Reducing tariffs will make the problem worse.
Our structural problem is that we have too low a long-term growth rate, due to a declining presence in the high-value growth industries. This leads to higher inequality. We must overcome the inflationary challenge and then focus on that long-term challenge, by positioning the economy to allow growth industries to grow, here and not elsewhere.
In an interesting article, Gabriel Mathy of American University and two other economists pointed out that in most modern (post-1970) inflations, the subsequent contraction drove up unemployment. But in the Korean War period, inflation fell from over 9% in 1951 to 2% in about a year, with no significant increase in unemployment. The prime reason was that wage and price-setters saw action was being taken to control inflation in two ways: through interest rates but also, crucially, through immediate capacity expansions to eliminate bottlenecks, snafus and shortages. Since our economy was mostly domestic back then, U.S. producers had the capability to invest quickly and expand capacity.
That experience offers an example of how tangible actions to increase capacity can reduce the cost of fighting inflation. To make our economy more flexible and responsive to shortages would require more domestic production, less oligopoly and a more flexible labor force. As Mathy and his colleagues point out, learning from history and “direct causal relationships” are often more valuable than statistical estimates that involve unobservable variables like the “natural rate of unemployment.”
