Federal Reserve Signals Recession; Needs Help To Fight Inflation

This week’s Courier Herald column:

The Federal Reserve, ignoring the simulative fiscal policies of the past few years, chose to ignore the early signs of inflation and called it “transitory”.  The U.S. is now experiencing the worst inflation since the 1980’s and even the Fed had to admit it was surprised that inflation increased between their last meeting and the one ending June 15^th – when they raised short term interest rates three quarters of one percent. 

Chairman Jerome Powell admitted in his press conference that inflation grew faster than expected, and thus they had to raise rates more than expected.  This puts the idea that the Federal Reserve is discarding their plan to engineer a “soft landing” – where they somehow tame inflation while the economy continues to grow.  Instead, it appears the Fed may be attempting to induce a recession to restrict growth and curtail the demand that is driving up prices.

A recession, while sub-optimal, isn’t the end of the world.  We’ve experienced mild recessions before where economists only officially declared one had happened after it was over. 

Technically, a recession is two consecutive quarters where the U.S. economy shows negative growth, or contracts.  It’s possible to have two mild quarters with only slightly negative growth, and two other quarters with robust economic activity resulting in a year with a recession but still a net growing economy.  The concern over a recession is how much an economy contracts, and how long the recession lasts.

Economic growth is measured in terms of Gross Domestic Product, or GDP.  There are four components that comprise this figure:  Consumer Spending, Investment, Government Spending, and Net Exports.

Consumer spending represents the bulk of the U.S. economy.  The amount of money we spend on goods and services represent about 70% GDP, using 2019 numbers before the pandemic skewed…everything.  This is why, especially in economic downturns, policies are geared to get consumers to open their wallets and spend rather than to save to get through the rough patch ahead.  Spending begets spending, which is the foundation of our economy.

Investment is a bit wonkier, as it only represents “new” investments, and not trading of existing stocks, and represents about 18% of the economy.  The gage to watch here isn’t something most of us would consider in investments, but businesses do. That would be inventory levels at both manufacturers and stores.

Inventories have been low for the past two years as supply chain issues have limited products available while consumers have basically bought everything that was available.  In the last month, however, major retailers have announced they have too much inventory and are cancelling orders.  So while their investment went up last quarter, they aren’t ordering as much to replace goods that aren’t selling.  This is a “leading indicator” that economic activity in some areas is slowing.

Government spending represents about 17% of the economy.  When the government buys a new computer system for an agency, or pays the salaries of government officials providing services those dollars count toward GDP.  Transfer payments where the government writes checks to individuals – Social Security, Welfare payments, stimulus checks, etc – are not counted as Government spending.  When recipients spend that money the economic activity generated is counted as consumer spending.  Interest on government debt is also excluded as it is a factor of what happed in the past, not present production.

If you’ve done the math, you see that these components represent 105% of the economy.  Net Exports, the final component, are negative 5% of the economy as the US imports more than it exports.  This money is subtracted from the other three to account for the percentage of our economic activity that is produced elsewhere.

Note that monetary policy controlled by the Federal Reserve mostly affects the consumer and investment components.  Fiscal Policy, a/k/a Government Spending, is in the purview of Congress and the Executive branch.  With interest rates rising, the cost of past government spending is going up without increasing GDP.

The area that could both bring down prices while helping GDP would be to increase domestic oil production.  This would reduce net exports while helping solve an international short-term supply issue. 

Right now, the Administration prefers to blame petroleum producers for very clear government policies to restrict supply.  At the same time, they blame the Federal Reserve for inflation despite years of overly simulative fiscal policy that only stopped when Senator Joe Manchin refused to go along with a plan to add trillions more to the fire.

The inflation genie is now fully out of the bottle.  Putting it back in will likely cause a recession.  The length and depth of this recession now lies on whether elected officials in Washington decide to accept their responsibilities with respect to fiscal policy and regulation that constricts supply, or decide to pretend the problem they helped the Fed co-create is solely the Fed’s problem to fix.