Advanced estimates suggest that real production has fallen for the second consecutive quarter in 2022, prompting many to question whether we are in a recession and what it means. The White House released a statement earlier this week advising the public to take a “holistic look at the data, including the labor market, consumer and business spending, industrial production and incomes,” which , according to them, it implies that we are not in a recession. My colleague Phil Magness describes it as “the White House’s attempt to work its way around a recession.”
I can understand why many are reluctant to conclude that we are in a recession. For some, the political stakes are too high. But others rightly note that the conventional approach to dating US recessions is more complicated than simply checking whether there have been two consecutive quarters of negative real output growth. The National Bureau of Economic Research (NBER) looks at several indicators to determine if there has been “a significant decline in economic activity that is widespread throughout the economy and lasting more than a few months”. And, at the moment, most of these other indicators look pretty good.
It is possible that better data will eventually see the two-quarter contraction revised. However, it is at least as likely that the contraction remains. And while it may seem odd to think that we are in a recession as the labor market looks so strong, it is entirely consistent with my view that monetary policy has been too accommodative for much of the past year. We overproduced during recovery and are now undergoing a corrective shrinkage.
I know what you are thinking. It wasn’t production under trends in 2021? How could we have produced overproduction if we were producing less?
First, it should be noted that overproduction does not mean overproduction. Rather, it means producing more than is justified given our abilities and preferences. Potential production – the amount we would like to produce given our capabilities and preferences – may decrease because we are less able or unwilling to produce. For example, every weekend my potential production collapses. I am able to work on Saturdays, but I would much rather turn on the grill, open a beer and watch my son do naughty things. You would have to pay me a lot to lose it, and most of the time, no one is willing to do it.
The pandemic has reduced potential production. Many people have preferred to stay at home rather than risk contagion. Government policies prevented some companies from operating for a while and discouraged some people from working. When those restrictions were lifted and the vaccines were launched, potential production began to recover. But the persistent supply chain problems associated with the pandemic continued to be a problem (to a lesser extent) throughout 2021 and were exacerbated by the Russian invasion of Ukraine in early 2022. Potential production is now very high. higher than in the second quarter of 2020, as we all tried to figure out how to deal with a new virus. But it remains below the pre-pandemic growth path.
The Federal Reserve should try to stabilize nominal spending. When monetary policy is too tight, nominal spending slows and output falls below potential. When monetary policy is too accommodative, nominal spending rises and output exceeds potential. By keeping nominal spending stable, the Fed can ensure that actual output coincides with potential output, so that no one is fooled with too much or too little production.
Nominal spending contracted sharply in 2020 and did not fully recover until the second quarter of 2021. Then it increased. This increase in nominal spending has deceived people into overproduction. It was difficult for many to see because we were producing less than we had before the pandemic. But the pandemic had reduced potential production. We should have produced less! Even though we were producing less, we weren’t producing sufficiently less given our abilities and preferences. Actual production exceeded potential.
We don’t look at the potential production. And it is very difficult to estimate. But one can speculate on what potential output might look like given standard economic theory and our knowledge of the nominal spending gap. I offer a speculative measure of potential output in Figure 1. Reasonable people may disagree on the magnitude of the difference between actual and potential output, but the sign of the difference (i.e., positive or negative) is consistent with the standard theory and available data.
An apparent correction
After the onset of the pandemic, real production recovered much faster in the United States than in other advanced countries. Many people touted the rapid economic recovery as a political success. In hindsight, it looks like the recovery has been also almost.
As a result of this too rapid recovery, it appears that we are experiencing a slight correction, which began in the first quarter of 2022. It is a bit like when you are recovering from an injury and you know you should take it a little easier than usual but, instead , try to do what you normally would and you end up feeling worse. We should have taken it a little easier in 2021. We hadn’t fully recovered yet, but we were trying to produce as if we had. We didn’t. And now that the mistake has been realized, the output is reverting to potential.
Here’s the good news: Aside from the interruption of the Russian invasion of Ukraine, potential production has likely continued to improve. This suggests that this recession will be short and mild. Production is returning to potential, but potential is returning to the trend. Growth may be slow in the third quarter of 2022, but I expect it to pick up later.
Continued improvement in potential output would also explain why labor markets continue to look so strong. Too quick recovery means that some have returned to work too quickly. They accepted wages that looked good at the time but, given the rapid rise in prices, have since turned out to be lower than they would have accepted had they known how high inflation would be. These workers are understandably disappointed and some will leave their positions if real wages remain low. But companies understand they need these workers to meet growing demand as the recovery continues and will raise real wages to keep them from leaving.
There are no guarantees, of course. In particular, there is a risk that the Fed will over-correct. If a tight monetary policy causes a sharp contraction in nominal spending, it could send us into a deep recession. However, the experience of the past year suggests that the Fed is much more likely to err in the opposite direction by letting inflation remain high.
The big risk, in my view, is not that we will have a deep recession. It is that we will have slower growth in the years to come. Persistently high inflation is expensive. It leads us to re-contract and adjust prices more frequently. The resources used to cope with high inflation are not used to produce other goods and services, so we produce less than we would otherwise.
To avoid a long period of slow growth, the Fed must quickly reduce inflation. Unfortunately, he doesn’t seem willing to do that. The summary of economic projections released in June suggests that inflation will remain high through 2024 and potentially longer. There is no good reason for this.
This mild recession will soon pass. Lower growth due to a higher trend inflation rate can persist forever, and it will if the Fed fails to do its job.