It Will Probably Take a Recession to Tame Inflation
The global pandemic produced widespread shortages, culminating in a level of inflation not seen in 40 years. When the surge in prices began more than a year ago, it was natural to assume that it would move back down on its own as supply bottlenecks faded away. But a different reality has become increasingly apparent: The easing of supply constraints will not be nearly enough to bring inflation back down to an acceptable level. Demand will have to weaken significantly–enough to push the unemployment rate up–and that spells recession.
There is no doubt that supply issues–initially brought on by the pandemic and exacerbated more recently by the war in Ukraine and shutdowns in China–have contributed to the rise in inflation. But it turns out that supply is not the main problem. In fact, it has been unusually strong: US consumer purchases of goods fully recovered by the end of 2020 and rose by more than 16 percent last year. Meanwhile, foreign producers have been delivering a record amount of goods to US consumers: Goods imports increased 19 percent in 2021 and have accelerated even further this year.
A surge in demand has been the primary driver of higher inflation, reflecting the extraordinary government stimulus that was applied to offset the severe economic damage from COVID-19. Strong public support was sorely needed following the extensive economic damage caused by the pandemic. But the unprecedented scale of fiscal and monetary stimulus turned out to generate a pace of demand that was well in excess of production capacity. US fiscal stimulus amounted to more than $5 trillion–a staggering 25 percent of GDP–more than five times what was applied during the Great Recession of 2008-09. Meanwhile, the Fed also went well beyond the historic monetary stimulus applied during the financial crisis: it bought $5 trillion worth of bonds in only 2 years versus $3.5 trillion over 6 years last time around.
All that stimulus, and the historically strong economic recovery that ensued, produced a surge in prices of all kinds–from bonds to stocks to houses to goods and services. Moreover, it took more than a year for the Fed to shift toward monetary tightening after inflation began to accelerate, allowing it to gain a momentum that makes it hard to reverse. Costs of production continue to accelerate. Prices that producers pay for goods are running at a double-digit pace, while the US labor market has never been tighter. The unemployment rate has declined from near 15 percent to around 3.5 percent in only two years and both job openings and quit rates are at record levels. There are nearly two job openings for every unemployed person, a gap larger than any ever recorded. As a result, labor costs are rising at a pace not seen in 30 years.
The economy is already slowing down from the post-pandemic surge, but not enough to lower inflation. Higher prices are reducing consumer purchasing power and financial conditions have tightened. But aggregate employee compensation, boosted by strong job and wage gains, is running well above the rate of inflation, enabling consumers to continue buying at a healthy pace. Housing activity is weakening as prices, rent and mortgage rates have soared, but is still characterized by excess demand. While stock and bond prices have fallen, they are coming from historically supportive levels and are not close to being restrictive. Bond yields remain well below the inflation rate, and overall stock market valuations are not cheap; they have merely moved back down to historical averages.
Most importantly, underlying economic fundamentals remain strong. Profits are holding up well, as companies are able to pass on higher costs to their customers. As a result, they continue to hire and increase capital spending. Household financials are also in very good shape: The hot labor market combined with massive government transfer payments have boosted income and savings. Consumer debt is not over-extended and wealth has grown rapidly due to higher stock and house prices.
While this suggests that a recession is unlikely this year, it also implies that it will take considerable policy tightening to reverse the uptrend in inflation. That is, unless something unexpected–like a negative geopolitical event—knocks the economy down. Otherwise, the burden of slowing the economy will fall squarely on the Fed, as a sufficient tightening in fiscal policy does not seem to be in the cards. Government spending, while declining, remains well above what it was prior to the pandemic and Russian aggression is likely to generate an increase in military appropriations.
All of this means that the Fed will eventually have to get to a restrictive policy stance. Markets are still not there yet, despite having ratcheted up expectations for Fed tightening this year. Futures price in a policy rate of around 2.5 percent for year end, which doesn’t seem unreasonable. But they also suggest a peak Fed funds rate of just under 3 percent in mid-2023, well short of restrictive since inflation is likely to remain considerably higher.
The reappearance of high inflation presents a much more difficult environment for financial markets. Low and stable inflation allowed the Fed to cut policy rates to zero and flood the financial markets with huge liquidity injections whenever an economic crisis appeared. Those days are over for the foreseeable future. The sharp drops we have seen in stock and bond prices this year thus seem appropriate, reflecting a new economic and policy reality. Financial asset prices were pushed to elevated levels by unprecedented policy support that is now beginning to be removed. The recent declines have taken much of the excess out of the markets and put them in a healthier position. In fact, there are now reasonable prospects for improved performance over the next several months given the underlying health of the economy along with realistic expectations for Fed hikes this year.
But markets are not priced for a recession. If the Fed ends up hiking rates well above 3 percent next year and the economy gets hit hard enough to move the unemployment rate up, stock prices will eventually drop to much lower levels. Higher policy rates and inflation that proves difficult to bring down also suggests that bond yields will eventually move up. The roughly 3 percent ceiling on 10-year Treasury bond yields that persisted for a decade prior to the pandemic will almost surely not hold through next year.
The bottom line is that this business cycle is likely to end up in a recession: the price for the excessive government stimulus that was applied during the pandemic. But this will take many months to play out and the path between now and then will not be straightforward.