A recession would be worse than today’s inflation

In recent months, the Federal Reserve has been under intense pressure to sharply raise interest rates in the name of curbing inflation. Voices calling for this speed often rise clearly say they’re worth doing even if they greatly increase recession risk. At its most recent meeting of the Open Market Committee, the Fed heeded those voices and raised rates by 0.75%, the largest single increase yet. 28 years“And expressed his intention to keep raising rates until inflation normalizes, even if it raises the risk of a recession.

The Fed’s actions to date do not guarantee a recession, but they have already made one more likely. Moreover, if they continue on the hawkish path for much longer, a decline is likely. This would be a huge and avoidable political mistake. Inflation is not called large macroeconomic imbalances between aggregate demand and supply. Wage growth already noticeably slowing down. In short, the goal of raising rates – to balance supply and demand and contain wage growth – has already been achieved.

In addition to not recognizing these points, many voices in these debates have directly or indirectly argued that recession and inflation cause equivalent damageor this inflation actually does more damage. than a recession. This point of view is clearly erroneous – the economic damage from recessions is much greater than from single-digit inflation.

BUT general argument argues that inflation hurts everyone in the economy, but a recession only hurts those who lose their jobs. This is the opposite of the truth. A recession directly reduces incomes across the economy, while inflation does not.

A recession is the result of underutilization of potential productive resources (primarily labor) (for example, rising unemployment). In short, it is a net waste in the sense that the economy produces less than it could receive if the potential resources were fully utilized. During Great Recession and the protracted recovery that followed, these losses amounted to approximately $20 trillion, or over a year the value of economic output.

Inflation, on the other hand, is a net redistribution in the short run, but does not directly reduce incomes in the aggregate. One person’s expenses are another person’s income. As prices rise, this directly leads to higher incomes for someone in the economy. 2021-2022 inflation has been admittedly regressive, leading to lower real (inflation-adjusted) wages for (most) workers but essential higher profits for corporations and for foreign exporters USA. But as much as we love the redistribution caused by recent inflation, there is no evidence that it has led to lower incomes overall (including global incomes outside the US). In addition, if we are to keep income distribution harmless to the effects of recent inflation, there are a number of policy instruments, such as tax redistribution and labor standards, that could do this.

Some may make the mistake of looking at the current rate of wage growth for workers (approx. 4.5% year on year) and the current inflation rate (8.6% Over the past year) and think that a recession may reduce inflation but not affect the growth of nominal wages. If this were true, the workers (at least those who stayed on) could theoretically benefit from an aggressive campaign against inflation. But this is wrong. High unemployment reduces wage growth a lot of more reliable and for large sums than it reduces inflation. The evidence for this is simple – regression which define correlation between inflation-adjusted wages and unemployment (or other indicators of labor market tightness), there is overwhelming evidence that tighter labor markets (lower unemployment) are associated with faster real wage growth. The impetus given by tighter labor markets to real wage growth is also very progressive. Low paid workers see bigger gains as labor markets tighten and Black workers see faster growth than white workers. In short, the benefits of high-pressure labor markets are large in aggregate and progressive in terms of distribution. Conversely, the costs of a recession are large and regressive.

People hope that Any Efforts to curb inflation will simply keep prices in check without slowing down wage growth, and will therefore be disappointed if these efforts are driven entirely by the weaker labor market caused by the Fed’s hike in interest rates. Simply put, if the Fed does instigate a recession (or even a significant slowdown in economic growth), inflation-adjusted wages for workers will be lower than they would have been without the recession.

This angle of wage growth is by far the most important reason why simply looking at the rise in unemployment during a recession is a drastic understatement of how many workers were affected by the recession. Other issues include higher rate of underemployment as well as fewer hours of work during a year. In short, the costs of a recession are not just limited to those workers who lose their jobs—they are incredibly widespread across the workforce.

While it is generally believed that inflation cannot directly reduce economy-wide income, some point to theories indicating that if inflation is maintained for a long time (several years), it may end up being harmful to overall economic growth. But the main channels through which persistently high inflation drives down growth are through its potential interaction with the income tax code, whose functions have historically not been properly indexed to keep economic stimulus neutral in the face of inflation. But most features of the US tax code are heavily indexed for inflation today. Also, those features that are not perfectly indexed to avoid distorting interactions with inflation can be fixed in ways that do not require draconian inflation control.

Of course, a sustained recession or a period of weak growth would also have a big impact on long-term growth. Extended periods when workers’ wages are kept low due to damaged labor markets are periods when firms the incentive to invest in productivity increases is blunted“Instead, these firms may be showing high profit margins simply because of wage suppression. These “scars“The impact of the recession on long-term potential growth is very large, and it will almost certainly eclipse any long-term effect from inflation in the coming years. Obviously, if US inflation rises to 50% within a few years, the effect of slowing growth will outweigh the effect of recession scars, but no one seriously believes that such scenarios are plausible.

Some of the arguments for faster Fed tightening argue that even if you think a recession is worse than inflation, it is almost impossible ever bring inflation back to more normal levels without raising interest rates high enough to even risk a recession. This mindset essentially states that inflation is a one-way ratchet that always rises only until a recession pulls it back down. It is not true. The most obvious example of this not being true is when most of the overall inflation is due to certain commodities such as energy and food. The prices of these commodities fluctuated wildly up and down and rose significantly. and then downward pressure on inflation without necessarily interfering with a recession.

This statement about a one-way ratchet in non-crisis times is also incorrect more generally. The key variable for determining the need for a softer labor market to contain inflation in the coming months is typically the rate of wage growth. If wage growth is consistently slower than inflation, then wages keep inflation down both on the cost side (labor costs rise more slowly than other costs) and by generating lower real household incomes, which reduces demand. As long as wage growth slows, inflation will recover without triggering a recession once the economic turmoil subsides. Currently, wage growth is slowing down. This means that there is no real need for a recession to bring wage growth down to sustainable levels.

One could, of course, argue that the reason for the current slowdown in wage growth is the recent increases made by the Fed and their success in lowering inflationary expectations. My own point of view is rather incomplete argument. But, even if one believed this, it seems clear that in the future the need to keep raising interest rates will disappear. The risk of a recession is now much higher than it was a few months ago, and the key reason for this is the increase in interest rates – both in the recent past and in the expected near future. The cost of a recession will be much higher than any gain from piling up more restrictive policies to curb an already waning inflation.