The writer is the founder of Sahm Consulting and a former Federal Reserve and White House economist
Some commentators argue that the US needs a recession to bring inflation down. That thinking hinges on a simplistic model of the economy and a refusal to see Covid and the war in Ukraine as important sources of inflation now. The stakes are too high to rely on such a questionable approach.
Yes, inflation is a hardship, and it hits those with the least the hardest. Among American families in the bottom 20 per cent by income, almost 60 per cent of their spending is on food, gasoline and housing. That’s a far bigger fraction than among high income families.
The prices of these necessities have risen rapidly since the pandemic began. As a result, the lowest income families, on average, spend more than $300 a month extra to buy the same amount of these necessities.
Even so, a recession is worse than inflation. A lost pay cheque or even lost hours would far exceed the extra monthly costs due to inflation. And the chance of losing one’s pay cheque is not the same for everyone. According to research from economist Hilary Hoynes and co-authors, in recessions it is usually higher for men, black and Hispanic workers, young workers and less educated workers. The adverse effects on the unemployed last for years. There’s too much to lose with a recession, especially now.
The US unemployment rate is 3.6 per cent, near its 50-year low. Over 450,000 new jobs a month have been created, on average, since the start of the year. Total compensation to all employees is up 15 per cent since the Covid recession began, two percentage points higher than inflation. In contrast, after the Great Recession, inflation outpaced compensation.
So, what is the commentators’ case for needing a recession? The labour market is too good, and inflation will come down only if millions lose their jobs. A model developed in the 1950s called the Phillips curve predicts that when unemployment rises, people have less income and spend less. Demand falls faster than supply, and inflation comes down. The higher the inflation, the more severe a recession the model says is needed.
There are numerous problems with this prescription. First, while the Phillips curve is intuitive, since the 1970s the data have looked more like a cloud than a curve. That is, there is a weak relationship, if any at all, between actual unemployment and inflation. Economists disagree with what ‘killed’ the Phillips curve, but it is widely understood that alone it is inappropriate for policymaking.
Then there is another problem with the we-need-a-recession view. It hinges on inflation being demand driven. Specifically, supporters of it blame inflation on the extra demand caused by the American Rescue Plan stimulus package and low interest rates from the Federal Reserve last year. That’s important, because the Phillips curve only makes sense if inflation is demand driven.
Again, this argument crashes into reality. Ongoing disruptions from Covid and the war in Ukraine are pushing up inflation, too. Adam Shapiro, an economist at the Federal Reserve Bank of San Francisco, estimates that less than one-third of monthly core inflation, which excludes food and energy, is due to demand. Moreover, monthly core inflation has already stepped down noticeably this year. It remains too high, but the progress is evident. It is appropriate for the Fed to raise rates now. It would be a grave mistake to cause a recession — nor is it intentionally trying to.
Furthermore, there is no increase in the unemployment rate that would produce microchips for new cars, end China’s lockdowns, defeat Vladimir Putin, drill oil and build apartments. The Fed raises interest rates and lowers demand, cooling off the labour market. Whether it inadvertently causes a recession or not, higher interest rates would not fix the supply problems and would probably make some worse by discouraging investments.
Congress should help ease inflation, too. For example, it could pass legislation to keep health insurance premiums low, reduce tariffs, build affordable housing and fund sustainable energy production. Only a handful of measures would bring down inflation quickly, but they would all pay off in the coming years and make the US economy more resilient in the next crisis.
We must aim to protect workers and their families and bring inflation down. These two goals need not be in tension, but it will take more than outdated rules of thumb and a misunderstanding of our economic challenges to do both. We need many things today; a recession is not one of them.