Falling inflation and unemployment in the US does not rule out recession – 04/18/2023 – Market

There are two entirely different ways of looking at the US economy today: what the data says has happened in recent months and what history warns could happen next.

Most recent data suggest that the economy is strong. The job market is incredibly better today than it was in February 2020, before the coronavirus pandemic ripped a hole in the global economy. More people are working. They earn more. The differences between them –of race, gender, education or income– are smaller.

Even inflation, long the dark cloud in the economy’s sunny sky, shows signs of dissipating. Government data released on Wednesday (12) showed that consumer prices rose 5% in March from a year earlier, the slowest pace in nearly two years. Over the past three months, prices have risen by the equivalent of an annual rate of 3.8% — faster than policymakers would like, but not faster than the full alarm of inflation at its peak last year.

Yet despite all the good news, economists remain concerned that a recession is on its way or that the Federal Reserve will cause one by trying to control inflation.

“The data are reassuring,” said Karen Dynan, a Harvard economist and former Treasury official. “The things that make us nervous are all the things we don’t have a lot of hard data about.”

Starting with the banks: most of the recent data predates the collapse of Silicon Valley Bank and the banking turnaround that followed. There are already signs that small and medium-sized lenders have begun to tighten their lending standards in response to the crisis, which in turn may prompt their client companies to reduce hiring and investment. The extent of the economic effects will not be clear for months, but many analysts – including economists at the Fed – said the turmoil increased the likelihood of a recession.

The Fed started raising interest rates over a year ago, but the effect of those increases is just beginning to show in many parts of the economy. Only in March did civil construction begin to cut jobs, even with the real estate market falling since the middle of last year. Manufacturers were also offering jobs until recently. And consumers are still in the early stages of grappling with what higher rates mean for their ability to buy cars, pay off credit card balances and take on other forms of debt.

The data that paint such an upbeat picture of the economy are “a look back at an old world that is no more,” said Ian Shepherdson, chief economist at Pantheon Macroeconomics.

Shepherdson expects overall job growth to turn negative as early as this summer, when the combined impact of Fed policies and the bank lending crisis hits the economy, triggering job cuts. Fed policymakers “have done more than enough” to tame inflation, he said, but seem likely to raise rates again anyway.

Other economists, however, argue that the Fed has little choice but to keep raising interest rates until inflation is definitely easing. The recent slowdown in consumer price growth is welcome, they argue, but is partly a result of falling energy and used car prices, which look set to rise again. Measures of underlying inflation, which iron out these short-term swings, only gradually declined.

“Inflation is coming down, but I’m not sure the momentum will continue if they don’t do more,” said Raghuram Rajan, an economist at the University of Chicago Booth School of Business and a former governor of India’s central bank.

The Fed’s goal is to do just enough to reduce inflation without causing such a severe pullback in borrowing and spending that it leads to widespread job cuts and recession. Finding that perfect balance, however, is difficult – especially as policymakers must base their decisions on preliminary and incomplete data.

“It will be extremely difficult for them to get the exact spot right,” Rajan said. “They would love to have more time to see what’s going on.”

A failure in either direction can have serious consequences.

The US job market recovery over the past three years has been remarkable. The unemployment rate, which was approaching 15% in April 2020, has fallen to the half-century low it reached before the pandemic. Employers recovered all 22 million jobs lost during the first weeks of the pandemic and added another 3 million. The intense demand for labor has given workers a rare moment of leverage, in which they can demand better wages from their bosses or go elsewhere to get them.

The strong recovery has especially helped groups that often lag behind in less buoyant economic environments. Employment has increased among people with disabilities, workers with criminal records, and those without a high school diploma. The unemployment rate among black Americans hit a record low in March, and wage gains in recent years have been fastest among lower-wage workers.

All that progress, critics say, could be lost if the Fed goes too far in its effort to fight inflation.

“In this small moment, we finally see what a job market is supposed to do,” said William Spriggs, a professor at Howard University and chief economist for the AFL-CIO. And the workers who will benefit most from the current strength of the labor market, he said, will be the ones who will suffer most from a recession.

“You should see from this point on what you’re really risking,” Spriggs said. With inflation already falling, he said, there’s no reason for policymakers to take that risk.

“The job market is finally hitting its stride,” he said. “And instead of cheering and saying, ‘This is fantastic,’ we have the Fed hovering over everyone, casting a shadow over this unbelievable set of circumstances and saying, ‘Actually, this is bad.’

But other economists warn there are also risks that the Fed will do too little. Until now, businesses and consumers have mostly treated inflation as a serious but temporary challenge. If, instead, they start to expect high inflation rates to continue, it could become a self-fulfilling prophecy as companies set prices and demand from workers increases in anticipation of higher costs.

If that happens, the Fed could have to take much more aggressive measures to contain inflation, potentially causing a deeper and more painful recession. That, at least according to many economists, is what happened in the 1970s and 1980s, when the Fed, under Paul A. Volcker, controlled inflation at the expense of what was, apart from the Great Depression and the pandemic, the most high unemployment rate ever recorded.

The real debate is not between the relative evils of inflation and unemployment, argued Jason Furman, a Harvard economist and former adviser to President Barack Obama. It’s between some unemployment now and potentially a lot more unemployment later.

“You risk losing millions of jobs if you wait too long,” Furman said.

There have been some encouraging – albeit still tentative – signs in recent weeks that the Fed may be succeeding in the delicate task of slowing the economy just enough, but not too much.

Data from the Labor Department this month showed that employers are advertising fewer job openings and that workers are changing jobs less frequently, both signs that the job market is starting to cool. At the same time, the pool of available workers has grown as more people have returned to the workforce and immigration has picked up.

The combination of increased supply and reduced demand should, in theory, allow the labor market to rebalance without causing widespread job cuts. So far, that seems to be happening: wage growth, which the Fed fears is contributing to inflation, has slowed, but layoffs and unemployment remain low.

Jan Hatzius, chief economist at Goldman Sachs, said recent labor market data had made him more optimistic about how to avoid a recession. And while that result is far from certain, he said, it’s worth keeping the current debate in perspective.

“Given the incredible downturn in the economy that we’ve seen in 2020 – with obvious fears of a much, much, much worse outcome – if you actually manage to get back to a reasonable inflation rate and high employment levels in a period of, say, three to four years would be a very good result,” said Hatzius.

Translated by Luiz Roberto M. Gonçalves