Monetary and fiscal policy were too stimulative last year, and now policy-makers must deal with the repercussions.
Monetary and fiscal policy were too stimulative last year, and now policy-makers must deal with the repercussions.
C onfirming the fears of economic observers across America, the Bureau of Economic Analysis estimates that real gross domestic product (GDP), the main measure of output in the economy, decreased by 0.9 percent at an annual rate in the second quarter of 2022. Real GDP has now fallen for two consecutive quarters, assuming data for either quarter is not revised upward into positive territory. Although most economists don’t technically define a recession as two consecutive quarters of negative real GDP growth, that is a popular rule of thumb for non-economists.
As such, commentators have been debating whether this announcement means the United States is in a recession. On Meet the Press, Treasury secretary Janet Yellen recognized that economic growth is slowing and that the two-quarter rule is a “common definition.” She then argued that despite this, we are not in a recession, pointing out that payrolls have grown by 375,000 net jobs on average for the last three months and that the National Bureau of Economic Research (NBER) — a private nonprofit research organization accepted by a wide consensus of the economic profession as the arbiter of recession — has not recognized one.
Are Yellen and others redefining “recession” in order to help the Biden administration as the president’s approval ratings fall, or is it true that the economy is better than it seems?
Yellen and other recession skeptics are correct that many of the metrics the NBER uses to make this determination do not suggest we’re there yet. As economist Jeremy Horpedahl explains, several of the variables (including industrial production, employment, and consumption) are looking good. Also, GDP data is often heavily revised, so it’s possible that the recent report is misleading, and it is fair to reserve judgment for now.
Nevertheless, there are several reasons to be at least somewhat concerned about the report and to worry that we may enter a recession this year.
Even if the common understanding of a recession is not economists’ definition, they tend to overlap. As the American Enterprise Institute’s Michael Strain points out, a recession has been declared each of the ten times the United States saw two consecutive quarters of negative growth. It’s not hard to see why. If the economy shrinks, then it’s difficult for the average firm to expand their operations, produce more, and hire more employees. Likewise, it is difficult for consumers to continue to afford their standard of living. This may not seem relevant if the GDP data is eventually revised and growth ends up positive. However, even low positive growth can still be a prelude to recession.
Second, several other signs in the GDP report point to a slowdown. Economist Joey Politano observes that “real final sales to private domestic purchases” — a long way of saying the sum of consumption and fixed investment — stagnated, which is typically a harbinger of recession. Real disposable income also fell, meaning consumers have less in savings.
Third, even though real GDP shrank, nominal or current-dollar GDP, which measures total spending in the economy, grew at a higher annual rate than it did last quarter. While this might sound good, when nominal GDP is well above trend, as it has been since last year, it causes inflation to rise. Nominal GDP growth and inflation have both been too high because the Federal Reserve neither tightened monetary policy nor offset the infusion of money into the economy from the American Rescue Plan.
Inflation has already been very painful for Americans, and now the Fed is desperately trying to engineer a soft landing by reducing inflation without creating a recession. Higher nominal GDP growth means a soft landing may be even harder to pull off.
It’s impossible to truly know if we’re going to enter a recession, or how severe such a recession would be. The unusually strong labor market may prevent (or at least ameliorate) a slowdown in economic activity in the coming months. On the other hand, the positive indicators the optimists cite may have peaked, and could soon follow the other trends and turn negative.
What is clear is that monetary and fiscal policy were too stimulative last year, and now policy-makers must deal with the repercussions: a slowing economy combined with high inflation not seen since the early 1980s. Let’s hope they interpret the situation correctly and get the next step right.