The Federal Reserve and recession fears

Inflation is rife, the Federal Reserve appears ready to raise interest rates higher than previously expected, financial markets are reeling, and recession rumors are in the air. All of this points to economic pain ahead, and how much pain will depend on whether Washington avoids more of the policy mistakes that got us into this mess.

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A recession is by no means certain, especially with a strong job market and consumers still dumping the government’s pandemic payments. But inflation is undermining consumer confidence, with the Michigan survey dropping to 50.2 in June from 58.4 in May, and from 85.5 a year ago. The more consumers believe that their real earnings will continue to decline, the less they spend to keep the economy afloat.

Business confidence has also fallen sharply. The NFIB Small Business Optimism Index fell again in May, and owners expecting better conditions in the next six months forecast a net 54%. This is the lowest in the survey’s 48-year history.

Business Roundtable business leaders aren’t feeling much better. CEOs’ forecasts for the next six months recorded the sixth largest drop in the history of the Economic Outlook Index.

This is what the uncertainty that inflation causes to the economy. Firms feel higher at the onset of inflation as nominal profits rise. But the euphoria fades as ingredient costs rise, workers demand higher wages, and consumers begin to reject more expensive goods and services.

None of this is an argument for the FOMC to ease the monetary tightening set forth this week. The Federal Reserve on Monday leaked that the Federal Open Market Committee may consider a 75-point rate hike, and financial markets fell on the news. But at 1%, the real Fed funds rate is still very negative, and the Fed’s fault is that it has been too easy for too long. The sooner the Fed breaks inflation, the better.

As Mickey Levy and Charles Plosser argue nearby, the Fed will probably have to go up a lot to get inflation back to its 2% target. One indication to watch on Wednesday is the extent to which the FOMC concessions are raising their expectations for the end point of interest rates from their average of 2.8% in March.

This inevitably means stricter credit terms. Fed Chair Jerome Powell said the aim of the current tightening is to reduce demand in the economy and ease a tight labor market. That means slower growth, which was already disappointing at -1.4% in the first quarter and at a paltry 0.9% in the second quarter, according to the Atlanta Federal Reserve’s Now-Tracking GDP.

Tighter money and the threat of a recession should also cause the White House to abandon its anti-growth fiscal and regulatory agenda. A slowing economy doesn’t need a $1 trillion tax hike, yet Senate Majority Leader Chuck Schumer is still trying to get Senator Joe Manchin to sign up for a smaller version of Rebuilding Better.

The odd claim is that higher taxes will somehow reduce inflation. But the main effect of the tax increase would be to reduce investment and further restrict supply, which would make inflation worse.

Democrats tried to raise taxes to break inflation in the late 1960s, but prices continued to rise. They raised taxes in 1993 in the name of lower interest rates, but the Greenspan Fed still had to raise rates in 1994. The only way a tax increase can reduce inflation today is if it leads to a recession.

And businesses and consumers worried about rising costs also don’t need new regulatory burdens, which the Biden administration is voluntarily adding. The wise White House might call for a regulatory moratorium, especially on domestic energy production.

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The economic point is that policy makers should pursue pro-growth fiscal, liberalization and trade policies to offset the effect of tightening money. It was the Ronald Reagan-Paul Volcker formula that broke the inflation of the 1980s and led to a boom.

We realize that the White House is unlikely to take this advice. Even as growth slows and markets slump, Biden spent Tuesday shouting to the AFL-CIO that more government spending and higher taxes on the wealthy are a cure-all for inflation.

But we don’t want a recession in sight of any president, more than Americans want the inflation killing Mr. Biden and his party in the polls as the midterms approach. We are here to help, Mr. President, but the Lord also helps those who are helping themselves avoid stagnation.

Wonderland: The White House now says the US economy is “in transition”. They got that part right. Images: Getty Images / Global Archive via AP Composite: Mark Kelly

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