Senior National Economist: A Recession Would Be Worse Than Current Inflation
Why overreacting to short-term problems could cause long-term economic pain
This article first appeared on the Working Economics blog of the Economic Policy Institute.
The Federal Reserve has come under intense pressure in recent months to raise interest rates sharply in the name of controlling inflation. The voices calling for these rate increases often say explicitly that they are worth it even if they significantly increase the risk of recession. At their last open market committee meeting, the Fed heeded those voices and hiked rates 0.75% – the biggest increase in 28 years – and signaled its commitment to keep raising rates until until inflation normalized, even if this increased the risk of recession.
The Fed’s actions to date do not guarantee a recession, but they have already made one more likely. Moreover, if they continue on a hawkish trajectory for much longer, a recession is quite likely. This would be a huge and avoidable political error. Inflation is not fueled by large macroeconomic imbalances between aggregate demand and supply. Wage growth is already slowing significantly. In short, the purpose of the rate hikes – to balance supply and demand and dampen wage growth – has already been achieved.
In addition to not acknowledging these points, many voices in this debate have implicitly or explicitly argued that recession and inflation cause equivalent damage, or that inflation actually causes worse damage than recession. This view is clearly wrong – the economic damage caused by recessions is far greater than that caused by single-digit inflation rates.
A common argument is that inflation hurts everyone in the economy, but only those who lose their jobs are affected by the recession. It is the opposite of the truth. A recession directly reduces economy-wide income, unlike inflation.
A recession results from an underutilization of potential productive resources (mainly labor) (increased unemployment, for example). In short, it represents pure waste in the sense that the economy produces less than it could produce with the full utilization of potential resources. During the Great Recession and the long recovery that followed, this waste amounted to about $20 trillion, or more than a year of economic output.
Inflation, on the other hand, is pure short-term redistribution, but does not directly reduce incomes overall. One person’s cost is another person’s income. As prices rise, this directly leads to higher incomes for someone in the economy. Inflation in 2021-22 has admittedly been regressive, leading to lower real (inflation-adjusted) wages for (most) workers, but significantly higher profits for businesses and for foreign exporters to states. -United. caused by recent inflation, there is no evidence that it has led to lower incomes overall (including non-US world income). Moreover, if we wanted to protect income distribution against the effects of recent inflation, there are a number of policy instruments such as tax redistributions and labor standards that could do so.
Some might make the mistake of looking at the current rate of worker wage growth (about 4.5% at an annualized rate) and the current rate of inflation (8.6% over the past year) and thinking that recession could lower inflation but leave nominal wage growth unscathed. If so, workers (at least those who remained employed) could in theory benefit from an aggressive campaign against inflation. But it’s wrong. Rising unemployment slows wage growth a lot more reliably and by larger amounts than it reduces inflation. The proof is simple – in regressions that identify the correlation between inflation-adjusted wages and unemployment (or other measures of labor market tightness), the evidence is overwhelming that tighter labor markets (lower unemployment) are associated with faster real wage growth. The boost to real wage growth from tighter labor markets is also very gradual. Low-wage workers see greater gains as labor markets tighten, and black workers see faster gains than white workers. In short, the benefits of tight labor markets are large overall and progressive in distribution. Conversely, the costs of the recession are large and regressive.
people hope that any The effort to contain inflation will only limit price growth without slowing the pace of wage growth, so will be disappointed if this effort is entirely driven by a weaker labor market resulting from interest rate hikes of the Fed. Simply put, if the Fed engineer a recession (or even a significant slowdown in the rate of economic growth), inflation-adjusted wages for workers will be lower than they would be without the recession.
This angle of wage growth is, by far, the most important reason why just looking at rising unemployment during recessions is a drastic underestimate of the number of workers who are affected by recessions. Other issues include higher underemployment rates and fewer hours worked over the course of a year. In short, the costs of the recession aren’t just limited to workers losing their jobs — they’re incredibly widespread across the workforce.
Although it is generally accepted that inflation does not directly reduce economy-wide income, some point to theories that if inflation were to continue for a long period (several years), it could eventually prove detrimental to overall economic growth. But the main channels through which sustained high inflation leads to lower growth are through its potential interaction with the income tax code, the features of which were historically not well indexed to keep economic incentives neutral in the face of inflation. But most of the features of the US tax code are largely indexed to inflation today. Also, characteristics that are not perfectly indexed to avoid distortionary interactions with inflation could be corrected in such a way that they do not require drastic inflation control.
Of course, a prolonged recession or a period of weak growth would also have significant effects on long-term growth. Prolonged periods when workers’ wages are kept low by damaged labor markets are times when the incentive for firms to make productivity-enhancing investments is blunted – such firms may instead post high rates of return simply by due to wage cuts. These “scarring” effects of recessions on long-term potential growth are very significant and they almost surely overshadow any long-term effect of inflation over the next few years. Of course, if US inflation rose to 50% for a number of years, the effects of retarding growth would outweigh the effect of the scars of recession, but no one seriously believes that such scenarios are plausible.
Some advocating for a faster pace of Fed tightening have argued that even if you think recession is worse than inflation, it is essentially impossible never bring inflation back to more normal rates without raising interest rates high enough to at least risk a recession. This thinking essentially argues that inflation is a one-way ratchet, only moving up until recession pulls it back down. It’s not true. The most obvious way not to is when a large part of overall inflation is fueled by certain commodities like energy and food. The prices of these commodities have fluctuated a lot and have driven up considerably then press down on inflation without a recession necessarily occurring.
This assertion of a one-way ratchet in times of non-recession is also not true more generally. The key variable in determining whether or not a looser labor market is needed to contain inflation in the coming months is usually the pace of wage growth. If wage growth is consistently slower than inflation, then wages dampen inflation both on the cost side (labour costs increase more slowly than other costs) and by generating revenue lower real prices for households, thus depressing demand. As long as wage growth slows, inflation will be brought down without causing a recession once the economic shocks subside. Currently, wage growth is slowing. This means that there really isn’t a need for a recession to bring wage growth back to sustainable levels.
One could certainly argue that the reason wage growth is currently slowing is the recent hikes undertaken by the Fed and their success in dampening inflationary expectations. My own view is that this is a rather incomplete argument. But, even if we believed in it, it seems clear that in the future, the imperative to continue to raise interest rates has disappeared. The risk of recession is much greater today than it was a few months ago, and interest rate hikes, both in the recent past and in the foreseeable near future, are a major reasons. The cost of a recession would be far greater than any benefit of piling on tighter policy to rein in already falling inflation.
Josh Bivens is director of research at the Washington, DC-based Economic Policy Institute (EPI), which first published this essay. His areas of research include macroeconomics, fiscal and monetary policy, economics of globalization, social insurance, and public investment.