Recent reports of a decline in real GDP have raised talk of recession. The first quarter’s setback is more technical than otherwise, but the nation’s ongoing inflation nonetheless points to recession of a more fundamental and significant sort a bit farther out on the horizon. That recession’s timing and severity remain open to question, but its ultimate arrival is as certain as things get in economics.
One of two things will precipitate it. Either the Federal Reserve (Fed) will bring it on by conducting a concerted anti-inflation fight — restraining credit and raising interest rates aggressively — or, even if the Fed fails to act aggressively, the inflation will create enough economic distortions to bring on a recession anyway. The first case will likely produce a less severe economic downturn sooner — say within 12-18 months — than the second, but recession nonetheless is in the cards.
This country faces such an ugly prospect because, contrary to Washington claims, today’s inflation problem is neither a “transitory” reflection of post-pandemic strains, nor is it the immediate result of the fighting in Ukraine. Rather, this inflation has its roots in a long period of fundamental policy mismanagement. True, post-pandemic supply-chain problems have contributed to inflationary pressures, as has the war in Ukraine and the economic sanctions put in place in response to it. But it is past monetary and fiscal policy mistakes that have made today’s inflation an intractable problem and raise the prospect of recession.
This period of policy mismanagement goes back more than a decade to the financial crisis of 2008-09. To deal with the exigencies of that situation, the Fed poured liquidity into financial markets, driving short-term interest rates down to zero and injecting liquidity directly into the economy by buying securities outright, what central bankers refer to as “quantitative easing.” At the same time, the Obama administration tried to ward off the ensuing recession with massively stimulative fiscal policies that greatly enlarged federal budget deficits. Though such policies were perfectly justifiable in the circumstance, the Fed and the administration, contrary to past practice, persisted in them even as the economy recovered. The Fed carried on its quantitative easing and kept interest rates near zero for years, while the federal government continued to run historically large deficits. It was not until 2014, five years into the recovery, that policy began to moderate and then only very gradually. After 2016, President Trump, made fiscal policy even more stimulative, and Biden built on that pattern, first to deal with the pandemic but in other ways as well. The Fed returned to its stimulative policy in 2019, even before the pandemic, and continued in that pattern until just a few weeks ago.
It was a classic prescription for inflation – vast budget deficits financed effectively by Fed money creation, the modern equivalent of running the printing presses. Inflationary pressure took a long time to develop. The seeds, after all, were sowed almost a decade ago. No doubt the delay tempted many in Washington to ignore the classic causes of inflation. Some, including former Fed Chairman Alan Greenspan, identified as a moderating influence how globalization gave the nation access to cheap sources of labor. Although this globalization effect lasted for some time, it could not last forever. Now that wages and shipping costs are rising in China and other former sources of cheap imports, 8-10 percent a year in some cases, this inflation-moderating influence has disappeared, and the country again faces the inevitable price pressures implicit in its policy mismanagement
The Fed has begun to react. It recently reversed the quantitative easing program that had poured trillions in liquidity on financial markets. It has also begun gradually to increase interest rates. It has hardly gone far enough. The Fed will need to absorb market liquidity more aggressively by actively selling securities on markets. And it will have to raise interest rates much faster and further. Consider that short-term rates, even after the Fed’s latest move, still stand at only 0.5 percent. In today’s inflation, a borrower will repay his or her lender in dollars worth 8.5 percent less in real terms. That is a much bigger number than the 0.5 percent earned by the lender. Effectively, the borrower has the use of the money for a year and gains in real terms 8.0 percent a year. This state of affairs is far from the kind of restrictive monetary policy needed to counter inflation.
For the Fed to change the nature of policy sufficiently will require rapid and large interest rates hikes – likely enough to drive down market prices and bring on a recession. The Fed, of course, might decide not to risk it. That seems to be the thinking behind the baby steps it has recently taken. But even if the Fed were willing to accept price pressures, the nation will still face recession. Left unchecked, the inflation itself will create one.
In such a case, the recession’s onset may be delayed, but the inflation will nonetheless prepare the ground for it. Prices pressures will create major uncertainties in business planning and so discourage the investment projects that would otherwise enhance the economy’s efficiency and productive potential. Workers, even if able to secure wage hikes, will still struggle to keep up with the rapidly rising cost of living and accordingly cut back on their real spending. Already this year, paychecks rising 3.5-4.5 percent a year, faster than in many years, still trail living costs by a wide margin. Inflation also will erode the value of dollar-denominated assets, like stocks and bonds. The resulting retreat in financial markets will further discourage investments in real productive capacities. Meanwhile, price pressures will redirect what investment monies are available away from productive projects and into inflation hedges, such as art and land speculation. All these distortions will bring on recession even if the Fed fails to act.
The economic downturn now in the cards could have best been avoided by following more thoughtful policies for the last decade. But even in the absence of such wisdom, Washington lost a precious opportunity in 2021 to shift policy quickly and perhaps blunt the force of developing inflationary pressures. Instead, Fed Chairman Jerome Powell refused to take matters seriously and insisted on describing inflation as “transitory,” as did Treasury Secretary Janet Yellen. Even President Biden, as late as last summer, claimed that the inflationary trend was “expected” and is “expected to be transitory.” (If it was expected, it appeared in no earlier forecasts from either the Fed or Treasury.) The president still has not acknowledged the inflationary reality, preferring to blame Putin. Prompt action could not have avoided all the inflationary pressure, but it could have eased the intensity of today’s troubles. Washington, however, frittered away the opportunity. Now the inflation rages and the recession looms.
