Perceptions of the American economy have changed dramatically. Not long ago, the country seemed to be enjoying a robust post-pandemic recovery. Supply-chain issues were causing some problems, but businesses were hiring, and financial markets were reaching new highs. Inflation prompted some anxiety, but all else seemed well. Today, the recovery that had looked so impressive seems to be faltering. Real gross domestic product fell in the first quarter. Inflation, which Washington authorities called “transitory,” now looks virulent and enduring. Talk of recession is common. While the first quarter’s GDP decline was likely more a technical than a fundamental matter, a recession does nonetheless loom on the horizon.
Inflation is the villain in this story. It gained momentum throughout 2021. At last measure, consumer prices stood 8.3 percent above year-ago levels, the highest rate in 40 years. Counter-cyclical monetary policies from the Federal Reserve—interest-rate hikes and constraints on credit flows—can precipitate a recession. If the Fed fails to act forcefully enough, unchecked inflation alone can cause enough economic distortions to bring one.
For more than a year, Washington refused to take inflationary pressures seriously. The White House connected early inflationary signs to post-pandemic supply-chain disruptions. More recently, it has blamed Vladimir Putin for gasoline price hikes, presumably because his invasion of Ukraine has induced most of the developed world to place sanctions on Russia, including on Russian energy. To be sure, both these developments have contributed to rising prices, but they are not the real problem. Today’s inflation has deeper and more fundamental roots, and consequently it will be harder to quell without causing an economic setback.
Seeds of this inflation were in fact planted more than a decade ago to deal with the exigencies of the 2008–09 financial crisis. The Fed drove short-term interest rates down to zero and otherwise poured liquidity directly into the economy by buying securities outright in financial markets, or “quantitative easing.” At the same time, the Obama administration tried to ward off the ensuing recession with massively stimulative fiscal policies, enlarging federal budget deficits.
Such policies were justifiable in the event but persisted even as the economy began to recover. The Fed continued 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 the policy began to moderate, and then only gradually. Nor did this policy mix stop with Obama and his Fed: it gained momentum under Trump and Biden, in part, but not exclusively, because of the pandemic. After a period of slight policy moderation between 2014 and 2018, the Fed returned to its extreme stimulative policies in 2019 and continued in that pattern until just a few weeks ago. During this time, the Fed created new money to buy some $5 trillion in Treasury debt—$3 trillion in just the last few years.
Without acknowledging the inflationary effect of these past policies, including on asset prices, the Fed has at least dispensed with its past insouciance and begun to take anti-inflationary action. It has taken steps to constrain credit growth by raising the benchmark federal funds rate to 1 percent and promises more such rate hikes in coming months. It has also begun to remove some of the inflationary liquidity circulating in financial markets and the economy by reversing the quantitative-easing program of past years. Instead of injecting money into the economy by buying securities directly, the Fed will now allow bonds to roll off its balance sheet. No such change has occurred with fiscal policy, however, as the White House continues to advocate deficit-widening policies.
Because no anti-inflationary budget restraint is likely anytime soon, the Fed will have to go much further than it already has to moderate price pressures. Consider that short-term interest rates, even after the Fed’s latest move, still stand at only 1 percent. In today’s inflation, a borrower will repay his or her lender in dollars that are worth 8.3 percent less than they were a year ago. Effectively, a borrower who has the use of money for a year nets a real gain of 7.3 percent. This state of affairs encourages borrowing and lending and is far from the kind of restrictive monetary policy needed to bring inflation under control.
If the Fed means to relieve inflationary pressures, it will have to raise rates a lot higher. The necessary rise would shock financial markets and the economy. Conceivably, the Fed could make the required moves deftly enough to avoid extreme negative effects, a so-called “soft landing.” History suggests, however, that such dexterity is unlikely. Without any estimate of timing, Fed chairman Jerome Powell has already indicated that such a result is entirely possible.
Even if the Fed fails to act forcefully, the nation will still face trouble as the distorting effects of unchecked inflation create recessionary forces. By erasing the real value of wage gains, for instance, inflation forces workers to cut back on their real spending and impair growth prospects accordingly. Already this year, an historically impressive 3.5 percent–4.5 percent rise in wages trails inflation by a wide margin. Inflation also generates enough cost uncertainties to induce businesses to hold back on the capital-spending projects that usually promote growth and increase the economy’s productive potential. By eroding the real value of dollar-denominated assets, such as stocks and bonds, rapid inflation produces an ongoing retreat in financial markets that destroys wealth and discourages investments in capacity expansion. Finally, inflation fears redirect investment money away from productive projects and into hedges, such as art and real-estate speculation.
Had the White House changed budget policy in 2021 or the Fed acted last spring to implement anti-inflationary policies, the desired economic “soft landing” would be more achievable than it is today. Denying the inflation problem for more than a year undermined confidence about the efficacy of policy and built into people’s minds an expectation that the price pressures will persist. Such perceptions give inflation a life of its own, as workers demand wage hikes to cope with expected increases in living costs and company managements readily grant them, secure in the knowledge that they can raise prices to repair any damage to the bottom line. These wage-price spirals are what made the inflation of the 1970s and 1980s so hard to quell.
As it is, policymakers at the Fed and the White House squandered a year in which prompt action could have made a difference. Now recession looms, perhaps as soon as early 2023. The recession will come even sooner if it results from forceful, anti-inflation monetary policies, as opposed to letting inflation go unchecked. But a policy-induced downturn would be shorter and less severe, and it would allow for a quicker recovery.
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