There is a growing optimism Jerome Powell’s Fed can engineer a so-called soft landing with its restrictive monetary policies, which means avoid an outright recession.
Why? First quarter 2023 GDP growth is predicted to be positive following strong Q3 and Q4 growth in 2022, and we are still fully employed. This is in part because the US economy has recovered faster from the pandemic than other countries.
But the Federal Reserve’s last attempt to engineer a soft landing with a 2 percent inflation target resulted in the Great Recession, the worst worldwide downturn since the Great Depression.
Alan Greenspan, the Fed Chairman and his Fed Governors at the time thought that if they raised the overnight Fed funds rate slowly enough, they could tame inflation while avoiding a recession.
The funds rate was raised in increments of 0.25 percent 16 consecutive times in a vain attempt to mitigate what actually occurred. It was an example of the Fed wanting to have its cake and eat it too.
It was a different time, however. Inflation soared then because the GW Bush administration in 2001 took their hands off regulations, allowing the falsification of credit ratings, while cutting taxes to create the first $trillion budget deficit in our history.
And many traders are under what may be a similar illusion; that a so-called ‘soft landing’ is achievable with the Fed holding to its 2 percent inflation target.
However, because inflation measures have never had more than plus or minus 2 percent accuracy, pressing for a 2 percent target could bring actual inflation to zero, which is tantamount to a recession.
This fact was explicated by David Wheelock, a St. Louis Fed group vice president and deputy director of research, in a 2017 podcast.
“The price indexes that are used to estimate inflation don’t necessarily include all goods and services in an economy. Furthermore, these indexes have a slight upward bias. So, when the observed rate of inflation is, say, 1 or 2 percent … the true measure is actually probably lower than that, closer to zero.”
Another well-known fact is that prices plunge substantially during recessions when consumers slow spending, which is portrayed in the above FRED of personal consumption expenditures, our best measure of consumer spending.
Consumption only dipped below zero once since 1950, during the 2007-09 Great Recession that was worldwide, as I said. All other recessions (gray bars in graph) showed a consumption drop that was quickly mitigated by the Fed reversing course and dropping their interest rates.
So what is different this time? The last recession lasted just two months—from Mar-April 2020—caused by the first worldwide pandemic in 100 years that shut down economic activity completely, rather than an over-heated economy.
The inflation rate quickly dropped to zero, but took off as quickly because of the $trillions in pandemic aid, igniting the latest inflation surge. Other countries are taking longer to recover, and so the supply-chains are playing catchup to the surging demand for more goods and services.
When will a new equilibrium between supply and demand be established? It’s hard to say with a fully employed economy and consumers so willing to spend.
Larry Summers is the preeminent inflation hawk, though he has softened his rhetoric of late as inflation has subsided. I repeat a recent quote of his from Bloomberg news that has been scaring financial markets.
“We need five years of unemployment above 5% to contain inflation -- in other words, we need two years of 7.5% unemployment or five years of 6% unemployment or one year of 10% unemployment,” said Summers said in a recent speech in London. “There are numbers that are remarkably discouraging relative to the Fed Reserve view.”
His remarks are based on an outmoded thesis of classical economic theory left over from the inflationary spiral of the 1970s; suppress demand by suppressing hiring and the labor market with very high interest rates rather than wait for healthier supply-chains.
And supply-chains are recovering. The US Chamber of Commerce just reported for all of 2022 that exports of goods and services increased $453.1 billion to $3,009.7 billion, passing the $3 trillion mark for the first time. Imports of goods and services hit $3,957.8 billion, up $556.1 billion from 2021 and the highest on record.
Increasing supplies should continue to bring down inflation, in other words. But holding to a 2 percent inflation target, though Powell had said the Fed would be flexible, almost guarantees a recession.
Harlan Green © 2023
Follow Harlan Green on Twitter: https://twitter.com/HarlanGreen
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