Will US Inflation Lead to Recession?
May 18,
2022
MICHAEL R.
STRAIN
While some economic indicators suggest that the
recovery remains on track, others show that consumers may be stalling out, and
that households and businesses are becoming increasingly pessimistic. The US
Federal Reserve will have to respond more nimbly to economic softening than it
did to strengthening in 2021.
WASHINGTON,
DC – Rapid consumer price inflation in the United States is masking signs of an
economic slowdown that could threaten the longevity of current growth. While
nominal personal consumption spending grew by 3.4% between October 2021 and
March 2022 (the most recent month for which data are available), accounting for
higher prices shows that personal consumption spending was flat overall. And
inflation-adjusted retail sales look even worse, having been flat since March
2021.
This
slowdown is also showing up in public-opinion data. A CNBC-Momentive poll last
month found that over half of Americans have already been dining out less, and
that over one-third have cut back on driving or canceled a monthly
subscription. Such spending reductions might grow in severity: 40% of
respondents said that if higher prices persist, they will consider canceling a
vacation; and 76% expressed concern that higher prices will force them to
rethink their financial choices.
Reinforcing
these findings, inflation has driven the University of Michigan’s consumer
sentiment index to its lowest point in a decade – lower even than in the spring
of 2020, when the COVID-19 pandemic caused an abrupt surge in unemployment and
a severe economic contraction.
Stagnant
spending and softening plans for future spending should not be surprising,
considering that inflation has reduced real wages for most workers. So far,
consumers have largely maintained current spending, despite what higher prices
mean for household budgets. But that won’t last forever, and it may not even
last into the second half of the year.
Consumer
spending represents the lion’s share of the US economy, but forward-looking
businesses may be planning for a slowdown as well. Last month, a survey by the
US Federal Reserve Bank of Philadelphia showed that manufacturing companies had
the lowest net expectations for increases in future activity since December
2008 – the depths of the Great Recession. More than 85% of firms said that
their input prices had increased.
Similarly,
in an April survey of small businesses by the National Federation of
Independent Business, only 4% of firms said that the next three months would be
a good time to expand, a decline by over half from six months earlier. Last
fall, it was more common for businesses to expect higher sales in the coming
three months; now, 12% more businesses expect lower sales during the next three
months than higher sales.
To be sure,
plenty of other indicators suggest that the recovery remains on track. But
these findings are troubling, because they point to the possibility that
consumers are stalling out, and that households and businesses are becoming
increasingly pessimistic. Accordingly, the US Federal Reserve needs to match
its plans – and its rhetoric – to all the data. While Fed Chair Jerome Powell
speaks of raising interest rates “expeditiously” to a level where monetary
policy is no longer stimulating demand, the hawks on the central bank’s
policymaking committee are pushing for even more aggressive action. For
example, James Bullard, the president of the Federal Reserve Bank of St. Louis,
wants to see the Fed’s policy rate reach the 3.25-3.5% range by the end of the
year.
That path
may ultimately be necessary. But given the flashing yellow lights – including
the slowdown of nominal average wage growth in April – the Fed should be
careful not to lock itself into a particular course of action by imprudently
conditioning market expectations with hawkish rhetoric. After all, the hawks at
the Fed may be overestimating how difficult it will be to cool the economy.
Normally, the Fed needs to induce layoffs to slow the economy. But today’s
labor market is tight because of excessive vacancies, not high levels of
employment. Reducing vacancies will prove easier than inducing layoffs.
Moreover,
financial conditions are already responding rapidly – and preemptively – to
potential monetary tightening, with Treasury bond yields rising and 30-year
fixed mortgage rates soaring from around 3% at the start of the year to over 5%
this month. On top of these developments, Russia’s war in Ukraine and the
economic slowdown in China will cool the US economy to some extent, further
reducing the Fed’s burden.
In
addition, long-term inflation expectations are reasonably stable, which means
that it should be easier for the Fed to reset short-term inflation now than it
was during the 1970s and 1980s, when long-term expectations needed to be re-established
from scratch.
The Fed
fell painfully behind the curve throughout 2021. Failing to see the extent to
which inflationary pressures were building, it poured gasoline onto an economy
that was already running hot. If economic conditions slow more abruptly than
the Fed expects, it will need to respond more nimbly to softening in 2022 than
it did to strengthening in 2021.
Whether the
US experiences a recession over the next year might hang in the balance.
Michael R.
Strain is Director of Economic Policy Studies at the American Enterprise
Institute.
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