Not a recession yet: Overly aggressive Fed rate hike increases recession risk
Yesterday’s data showing negative gross domestic product (GDP) growth for the second quarter in a row sparked debate over whether the US economy is in recession. Below are some brief thoughts interpreting the numbers, as well as some more general questions about recessions and inflation.
- Most likely, we are not currently in a recession, even though we had negative GDP growth for two consecutive quarters. The “two quarters in a row” recession criterion is a rough rule of thumb. The more commonly used arbiter of business cycles in the US is the National Bureau of Economic Research’s Business Cycle Timing Committee, which weighs changes in many economic variables to determine recession start and end dates. The most notable statistics that refute the notion that we are currently in a recession are unemployment and job growth. Both stay pretty strong.
- The negative growth in the first quarter of 2022 was mainly due to statistical quirks that masked the real strength of the economy. In particular, exports have been rather weak and imports quite strong, but both can be very volatile. For example, net exports in the second quarter were positive and supported growth. But if I had to choose one of the indicators of the strength of the domestic economy, which excludes volatile indicators that can make noise in our estimate, I would choose the growth of domestic demand (officially known as final sales to domestic buyers) is a measure of spending by households, businesses, and governments in the United States that excludes volatile changes in firms’ inventories. In the first quarter, this growth in domestic demand was quite strong and amounted to 2.0%.
- Conversely, fundamental growth was weak in the second quarter. Domestic demand growth actually declined in the quarter. In addition to this fundamental weakness, a statistical quirk—the huge decline in the contribution to GDP caused by changes in firms’ inventories—also had an extraordinary effect on economic growth.
- In short, negative growth in the first quarter of 2022 looked much worse than it was. This is much less true for negative growth in the second quarter.
- The weakness of yesterday’s report bears the fingerprints of the Federal Reserve’s interest rate hike. On the eve of this week, the Fed sharply raised interest rates (by 0.75% – the largest single rate increase since 1994) at its last meeting. Rising interest rates tend to have a strong impact on business and residential investment. These were key indicators of weakness in the Q2 report. Business spending on structures and equipment declined, and housing investment fell at the fastest pace since the pandemic downturn in the second quarter of 2020. Excluding this quarter, housing investment declined at the fastest rate since 2010, following the Great Recession. .
- On Wednesday, the Fed again sharply raised rates by another 0.75%, a very significant rate hike that will add to yesterday’s weakness in GDP. Perhaps the Fed has already missed the mark and secured a recession in the coming months. But in any case, they should significantly slow down the pace of rate hikes in the coming months and be ready to move to neutral or even cut rates if weakness persists.
- Yesterday’s report showed substantially slowdown in the most important price index that the Fed should be watching. Core prices (excluding food and energy) rose just 4.4% year-on-year, the slowest pace since the first quarter of 2021.
The recession in the coming months will be extremely worrisome. To a large extent, this would be the result of a policy mistake by the Fed tightening interest rates too quickly, which could have been avoided. If a recession occurs when inflation remains high, mainly due to Global developments in the energy and food markets – the Fed may feel pressure not to cut rates to pump the remaining inflation out of the economy. This would be extremely destructive and threaten to prolong the recession.
Finally, if the wrong narrative prevails that today’s inflation was caused by too generous bailouts, it could be even more difficult for Congress to take the necessary recovery action. In short, the inflationary episode we are in could cause political indecision about a future recession, and that could end up being the biggest cost of inflation for US households.
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