Against panic: The Fed should not be given permission to cause a recession in the name of inflation control

The disappointing May data on consumer prices—showing continued strong growth of overall inflation and no real reduction of core inflation—seem to have been a turning point in how many influential policymakers and analysts view the U.S. inflation problem. In particular, it has inspired near-panic and damaging exhortations that the Federal Reserve should push the economy to the brink of recession in the name of fighting inflation. It has also led to preemptive absolutions of the Fed of any criticism that might come their way if a recession does result from steep interest rate increases.

This panic is unwarranted, and the Federal Reserve should not feel free to ratchet up interest rates without regard to the risk of recession. Years from now, a recession induced by the Fed raising rates too quickly will be seen clearly as a policy mistake that could have been avoided. This conclusion stems from several simple facts:

  • Both real output and the economy’s underlying productive capacity (potential output) are essentially in line with what pre-pandemic forecasts projected by mid-2022. None of these pre-pandemic forecasts indicated this would imply economic overheating by now. Given this, the macroeconomic balance between demand and supply cannot be so out of alignment that it explains a large share of the acceleration of inflation in the past 15 months.
    • Crucially, potential gross domestic product (GDP) was clearly above actual GDP for most of 2021 when inflation started. This is very hard to square with macroeconomic imbalances driving the rise of inflation.
    • Finally, there is rich, existing literature on the degree of inflation to expect given an overshoot of aggregate demand over potential supply. These estimates imply substantially less inflation than we’ve seen to date, meaning that factors besides simple macroeconomic imbalances are likely at play.
  • While the May price data were discouraging, there is reason to think that some of the drivers of inflation in recent months may be losing steam.
    • Profit margins are still at historically high levels but have come down significantly in 2022.
    • Wage growth has lagged inflation over the entire episode and has even decelerated in recent periods. This means that wages’ role as a dampener of inflation looks set to continue (and maybe even strengthen) in coming months.
  • The main channel through which higher interest rates will put downward pressure on prices runs through a softer labor market (higher unemployment) reducing growth in labor incomes, which reduces demand and reduces pressure on prices from the cost side as well. But, labor income growth has not been a key driver of inflation so far; in fact, wage growth has significantly dampened the growth of inflation over the past 15 months. In the past six months, hourly wage growth is actually running at a pace entirely consistent with the Federal Reserve’s 2% long-run inflation target.

It has become fashionable to confidently assert that the Fed was “caught flat-footed” by the rise in inflation. This assertion combines bad judgement on two fronts. First, it’s a far too-confident political judgement that inflation clearly reflects worse on policymakers’ judgement than a recession would. Second, it’s a clearly flawed economic judgement about the sources of the inflationary surge in 2021 and 2022, as well as what is necessary to return inflation to normal levels. Put simply, the primary inflation-relevant variable that the Fed’s policy actions can affect—labor income growth—has been dampening inflation over this entire period. Given this, it is far from clear that the Fed should have acted much more aggressively or that the Fed’s seeming turn to a more-aggressive policy going forward is welcome.

However, the Fed is absolutely setting themselves up to get caught flat-footed in the near future if a steady diet of interest rate increases throws the economy into recession. The recently oft-repeated formulation that the Fed must do “whatever it takes” to push down inflation is downright reckless. Monetary policy operates with a lag. By the time it’s clear in the data that the labor market has been deeply damaged by interest rate increases, it will be too late to avoid a recession.

The fact of faster inflation is not proof of large macroeconomic imbalances

There is a growing willingness to point to the simple fact of fast inflation as evidence that it has been caused by a large macroeconomic imbalance of aggregate demand running far ahead of the economy’s productive capacity, and that only contractionary policy can remedy this imbalance. This is flawed economic reasoning, for a couple of reasons.

For one, the level of output currently being produced in the United States, and the underlying productive capacity of the economy, are essentially in line with projections made for early 2022 by forecasters before the pandemic. These forecasts had no sign of inflation in them. If we’re in line with those, then, it is quite unclear why the current level of output could not be produced without lots of inflation.

For another, past episodes of the economy “heating up” as unemployment falls and inflation accelerates have been universally accompanied by real (inflation-adjusted) wage growth and a rising labor share of income. The past 15 months have seen the opposite: falling real wages and a rising profit share.

Figure A below shows both real gross domestic product (GDP) and potential GDP (what the economy could produce if unemployment was roughly 4%). Each line is the ratio of the current estimate relative to pre-pandemic forecasts. For a current estimate of potential GDP, I adjust for the lower labor force participation rate and the (slight) shortfall in business investment that has occurred since the pandemic began. It is perhaps underappreciated how little gap remains now between pre-pandemic forecasts of potential GDP and reasonable estimates of its current value—the labor force participation rate is near-totally recovered and investment has been growing tolerably well since the pandemic recession in 2020.

Relative to pre-pandemic forecasts, the U.S. economy should be able to produce today’s level of ouput with very little inflation: Ratio of forecasted real GDP to actual GDP and forecasted potential GDP to estimated potential GDP

Real GDP Potential output
2019Q3 100.0% 100.0%
2019Q4 99.9% 100.0%
2020Q1 98.1% 99.9%
2020Q2 88.8% 97.3%
2020Q3 95.0% 98.0%
2020Q4 95.5% 97.9%
2021Q1 96.5% 97.8%
2021Q2 97.7% 98.0%
2021Q3 97.9% 98.1%
2021Q4 99.1% 98.3%
2022Q1 98.3% 98.9%
2022Q2 98.4% 99.3%
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