Voters’ impression of today’s economy can be summed up in one word, “inflation.” As is presently the case, an expanding economy is sometimes accompanied by inflation. Sometimes inflation accompanies a sagging economy, or even a full-blown recession, known as “stagflation.”
Although both recession and inflation hit people unequally, inflation is generally more politically toxic than recession. With recession, and, for example, an eight to ten percent unemployment rate, the unemployed obviously are hardest hit. Other workers remain employed and, as long as aggregate demand remains strong, businesses remain profitable.
A popular notion is that “inflation hits everybody.” Sure, everybody pays high prices. But inflation nevertheless hits people disproportionately. Inflation favors borrowers over lenders as borrowers repay their loans in cheaper dollars. Hardest hit are low income earners who spend a greater proportion of their income than high income earners. Low income earners, who have no bargaining power in the work place, and small business that cannot raise prices sufficiently to cover increasing costs, suffer more than large businesses that can, and do, raise their prices to cover costs.
Nevertheless, since everybody pays higher prices than to which they are accustomed, inflation is noticed by all, and is politically toxic.
It is elementary economics that if demand for goods and services increases relative to supply, prices rise. By similar logic, if supply decreases relative to constant demand, prices rise. And if supply remains static, or decreases, relative to rapidly increasing demand, the stage is set for rapidly rising prices. That is what we have today.
Today’s lagging supply coupled with rapidly increasing demand are direct results of the pandemic and the economic recovery, exacerbated by extraneous factors.
During the pandemic, production of oil and many other goods and services was restricted. Spending remained low both because of cautionary health practices and limited availability of goods and services. Because of reduced spending, and economic rescue packages of both the Trump and Biden administrations, some people managed to save money, and the national savings rate actually increased.
As the pandemic eased, with the pent-up demand for goods and services, and available cushions of savings by the economically fortunate, spending increased dramatically, even as supplies remained restricted because of supply chain issues exacerbated by the war in Ukraine. Hence, a politically toxic expansion of demand relative to stagnant supply of many goods and services — a world-wide situation not restricted to the U.S. And, of course, the U.S. political mandate to get it under control.
The domestic agency responsible for maintaining stable prices consistent with full employment is the Fed. The problem with this is that current inflation is disproportionately a supply problem, inability to meet increased spending that normally is expected during an expanding economy. Against what is significantly, if not mainly, a supply issue, the tools available to the Fed are limited to the demand side, mainly through raising interest rates to reduce borrowing and spending.
The Fed has embarked on its recent .75 percent increase in short term interest rates, and with the June Bureau of Labor Statistics report, the Fed is anticipated to follow with further increases of this, or greater, magnitude. These unusually high interest rate increases, and anticipated increases, have sparked the current debate of whether a recession is in the winds. Will rates sufficiently high to curb inflation bring on a recession?
Some observers assert that “we are already in recession.” Let’s be clear; we are not currently in recession. Spending remains vigorous and the recent jobs report exceeded expectations.
The major concern is whether the Fed can engineer a “soft landing,” that is, tighten monetary policy enough to bring down inflation without causing a recession. Given this supply-oriented inflation, and the Fed’s tools limited to the demand side, this hoped for “soft landing” is much to hope for, but difficult to achieve for an agency ill-equipped to solve supply issues.
So is a recession inevitable? As baseball’s homespun sage, Yogi Berra, reminded us, “It’s hard to predict stuff, especially when it’s in the future.” Economists cannot predict the future, but neither can anyone else. Yet, even if only implicitly, we all make assumptions about the future. Bankers and money managers are all over the place with warnings and recommendations regarding the economy and financial markets.
Authoritative figures, or at least those claiming such status, are predicting anything to which an individual is inclined to believe, ranging from impending financial disaster to merely an expected pause in inevitable expansion of the economy and financial markets. Many reasonably believe that, if not a full blown recession, we will surely have an economic slowdown. But they vary on the timing — from the 4th quarter of 2022 to various times in 2023.
It depends on many things, including how aggressively the Fed raises rates, and reaction to it. Will aggressively raising rates dampen demand enough to cause a full blown recession? Or will aggressively raising rates nurse optimistic expectations that inflation will be curtailed, resulting in consumer confidence and rising financial markets? Or will some combination of world-wide good luck and a needle-threading Fed result in a “soft landing?”
If the Fed’s tools are limited to the demand side, what can be done on the supply side to take pressure off prices?
Steps to increase supply involve public policy, hence politics. These include increasing sources of energy beyond oil, rebuilding the work force to compensate for retiring Baby Boomers, and rebuilding decaying infrastructure. But these are long-run fixes, in the power of politicians famously restricted to short-run thinking — topics for another day.
— John Waelti’s column appears monthly in the Times. He can be reached at jjwaelti1@tds.net
