Not a Recession, Yet
We are not in recession, but inflation is taking a toll on the health of the economy.
Real GDP contracted at a 0.9% annual rate in the second quarter after tumbling at a 1.6% pace in the first quarter. The headline is stunning as we typically associate two negative quarters in a row with recessions.
The only time the economy was not deemed a recession following two sequential negatives was in 1947. A large drop in defense spending and drawdown in inventories following World War II did not trigger a commensurate loss in employment, consumer spending or production.
The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) is the official arbiter of recessions. It looks at an array of economic indicators, not the least of which is employment, to determine whether the overall economy is actually in a contraction.
Payroll employment remained robust in the first half of the year, despite the declines in the accounting of real GDP. Job openings were so high and staffing shortages so acute that firms kept hiring at a red-hot pace even as demand cooled. We were coming off of the frenzied paced triggered by reopening the economy in 2021.
The unemployment rate, which can be another indicator of whether the economy has slipped into recession, is still low. It held at 3.6% in the second quarter, close to the record low 3.5% we saw in February 2020.
That begs a few questions. Why do so many Americans feel so bad about the economy? And what happened in the second quarter? The answer to the first is easy. Inflation burns. What we achieved with rising wages when we emerged from initial lockdowns was quickly lost to the fires of inflation.
The answer to the second question is a matter of accounting. A slowdown in consumer spending and an improvement in the trade deficit were not enough to make up for the collapse of the housing market, a slowdown in inventories and a drop in government spending. Business investment essentially flatlined, which reflects increasing concerns about growth going forward.
Some of the losses we endured were quirky. The drop in federal spending was almost entirely due to how the government accounts for the administration’s efforts to drain the Strategic Oil Reserve (SPR). The problem is that oil was already produced; the government has to offset the decline in the official GDP statistics with an increase in oil inventories and a drop in imports of oil relative to exports. Indeed, a portion of the improvement in trade was due to a narrowing of our dependence on foreign oil.
An end to pandemic aid added to the weakness in federal spending. Moreover, any increase in spending agreed to in the Senate’s new environmental and tax deal is not likely to add to federal deficits as it also raises taxes. There is a minimum 15% tax for large companies that do not currently pay taxes; it increases carried interest and tax bills for private equity firms.
The tax law changes are not as large as Treasury Secretary Janet Yellen has proposed in her efforts to coordinate a 15% global minimum tax. They could be significant and offset the federal stimulus associated with increased federal spending and the infrastructure bill. The spending will take time to ramp up; infrastructure projects take a particularly long time to get up and running.
The persistent drop in state and local government spending is more of a puzzle. State and local coffers filled during the pandemic in response to the surge in tax revenues generated by the jump in spending on goods and homes, the rebound in employment and the pivot to online learning. School districts across the country actually saved money because of the cost savings triggered by the pivot to online learning.
Those gains are all in addition to the pandemic aid that state and local governments received; they are still figuring out how to deploy those funds.
The larger issue is whether the economy will slip into an actual recession later this year or in 2023. The answer to that rests in the persistence of inflation, the additional tightening of credit markets triggered by recent rate hikes - we have yet to feel it all - and the Federal Reserve’s willingness to continue raising rates.
Fed Chairman Jay Powell made his view clear at the press conference following the FOMC meeting; if the Fed is forced to choose between reining in inflation and suffering a recession, it will suffer the recession. The worst mistake the Fed can make is to let the cancer of inflation go unchecked. The problem is that the Fed lacks the precision to remove that cancer skillfully. It can’t calibrate the degree to which the economy contracts.
We are not in a recession, but inflation is taking a toll on the health of the economy. Alleviating the threat of a more chronic inflation would be painful. It would likely mean an increase in unemployment that could tip the economy into an official recession. For the moment, the Fed is willing to take that risk rather than suffer the erosion of living standards triggered by inflation.