Despite recent job-creation numbers, here’s what will result from the monetary- and fiscal-policy mistakes of the last two years.
We are likely to slide into a full recession, potentially sometime in the first half of next year.
D espite much hair-splitting this summer over whether the United States is “in a recession,” the labor-market data released today indicate the economy is continuing to create jobs for Americans. In August, the economy added 315,000 jobs, and wages grew 5.2 percent over a year ago — more than 3 percent below the rate of inflation.
Job creation matters because it helps offset the reduction in spending power that each individual household faces as a result of 40-year-high rates of inflation. Even though each family is experiencing a decline in its real spending power — after inflation, real wages have cumulatively fallen a stunning 5.6 percent since the end of 2020 — enough people are going from nonemployment to employment to offset this drag in the aggregate data. The solution to the puzzle as to why we aren’t in a recession, despite the economy feeling awful for most households, lies in these two forces colliding.
While a recession is typically accompanied by shrinking activity across most sectors of the economy, weakness, to date, has been pretty concentrated: in imports in the first quarter and inventories in the second. While the economy may not yet be in a significant downturn, it has all but come to a standstill — private, final domestic demand growth was 0.2 percent in Q2 after stripping out volatile imports and inventories — and inflation is making every household feel much poorer.
With growth at a standstill and households getting crushed by inflation, hearing the Biden administration bend over backward to argue that “we’re not precisely in a recession” is akin to being punched in the gut and then told, “Well, that’s not technically your gut; that’s a few inches up.”
Although the economy has maintained just enough momentum for job creation to offset the squeeze on families, we don’t expect it to last. The enormous monetary tightening delivered by the Federal Reserve since the winter will catch up with us, but with the usual lag between when policy changes and when it’s detectable in the data. Economists typically think these lags vary from twelve to 18 months, but the speed and size of the Fed’s hiking cycle may mean lags are shorter than usual.
Hiking short-term interest rates and thereby inducing a recession is the Fed’s standard response to too-high inflation. A historical examination of post-war recessions indicates that the median hiking cycle to induce a recession is about 3.3 percent. The bond market expects the current hiking cycle to bring hikes of 4 percent to the federal funds rate. But balance-sheet operations matter, too: both the Fed’s tapering of its bond purchases — which ended in March — and “quantitative tightening,” or allowing its assets to roll off its balance sheet on maturity. By my calculations, those operations will provide another 2 to 4 percent of fed-funds-equivalent hikes, resulting in a total cycle of 6 percent to 8 percent. In the context of history, this is roughly twice a typical hiking cycle and, we think, more than enough to induce a recession — eventually.
So, while the economy has continued to create jobs over recent months, don’t count on that phenomenon’s lasting. Instead, we expect that the economy is likely to slide into a full recession, likely around the turn of the year, but potentially sometime in the first half of next year. When that happens, it will begin shedding jobs, firms will stop offering wage hikes to employees, households will cut back spending, and inflation will begin its descent toward target. There are some early signs of the start to this cycle, as the number of hours worked by each employee has declined in recent months — hours worked often leads employment, as firms adjust hours for existing workers before making decisions on hiring and layoffs.
Once inflation comes down, the Fed can start cutting interest rates, and the business cycle will begin anew. The fact that people will lose their jobs in order to bring inflation down is a tragic loss and indicative of the enormous and reckless monetary and fiscal mistakes that policy-makers have made in the last two years in allowing inflation to become as grave as it has.