“Having been forced into being the only game in town, they (Federal Reserve) now find their destiny in no longer entirely or even mostly theirs to control.” – Mohamed Aly El-Erian (Egyptian-American economist)
This quote from the 2016 book (The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse) befits the puzzling economic reality in the United States. Shrugging inflation as transitionary last year, the US Federal Reserve has purposefully shifted to the other side of the monetary spectrum. After not increasing the interest rates last year, the Fed has delivered a quarter-point, a half-point, and two back-to-back three-quarters of a point hikes since March. Consequently, the fears of a stark economic slowdown have compounded as critics have flagged selective metrics to convince the onlookers that the United States is already in a recession. However, while some signs allude to the possibility of an end of the business cycle, the objectivity of robust economic resilience is still hard to deny!
The Federal Reserve announced its fourth rate increase of 2022 on Wednesday in a precedented session. Citing job gains, elevated inflation, and supply chain imbalances, the Fed officially justified its second consecutive 75-basis points rate hike. And while Fed Chair Jerome Powell reiterated the notion of “not in a recession yet,” the official statement by the Federal Open Market Committee (FOMC) projected the feared forward guidance – their unanimous inclination toward slower economic growth even at the cost of substantial job losses. This rate hike is significant due to the extended period until the next meeting in September. Given the sharp disinflationary guidance manifested by the Fed throughout the first half of this year, the next meeting would be pivotal to the delicate balancing act between sustainable growth and price stability. Moreover, the latest rate increase has effectively bumped the Federal Funds Rate (the interbank overnight borrowing cost) between 2.25% and 2.5% – a range widely acknowledged as neither aggressive nor lenient. Yet with an expected target to extend the rate to about 3.4% by December this year, the next month would be crucial to watch for any cooling effects – stemming from the ripples of monetary tightening – that may legitimize smaller increments in the second half.
Many economists argue that the Fed is moving too fast – perhaps worsening the blow of a recession instead of steering toward a smooth landing. Even a few US lawmakers, including Democrat Senator Elizabeth Warren, have opposed the hawkish maneuvers of the Powell-led central bankers. Their arguments are not all unjustified. For instance, the Yield Curve – a graph charting the relationship between the annual returns of 2-year and 10-year treasury notes – has been in inversion throughout July. History shows that an inverted yield curve has always preceded an economic downturn in the United States. And presently, the bond market signals indicate that investors doubt the ability of the Federal Reserve to swerve past a recession. According to the Bureau of Economic Analysis (BEA), the US economic output, gauged by the Gross Domestic Product (GDP), contracted for a second successive quarter – signaling a sustained decline in economic activity. And even fillings for unemployment listings – a bellwether indicator of layoffs – have climbed slightly higher in recent weeks. The confluence of these factors substantiates the arguments of the Fed critics claiming a recession is already in play. However, the antipode argument is also intriguingly convincing!
According to the National Bureau of Economic Research (NBER) – the official corroborator of recessions in the US – an economy is in a recession when there is a “significant decline in economic activity that spreads across the economy, and that lasts more than a few months.” Following this definition, we should not focus on just a few sectors of the US economy to gauge the broader economic health. So to assess the first claim, let us examine the data to answer: Are we already in a recession?
Most probably not! I admit the yield curve has historically been an omen of economic collapse in the US. But a chronology of US recessions depicts that economic downturns usually start after the graph has normalized. For instance, the Great Recession officially began in December 2007 – months after the yield curve had already reverted. It is because a recession usually starts off after the Fed has completed its tightening schedule and begins to lower the rates again. Thus, a lag in policy transfer over time leads to this phenomenon.
While the GDP contracted for the first half of this year, that is also not a sure-shot indicator of an economic downturn. It is because mainstay sectors of the US economy – like the Housing and Automobile industries – could drag down the measure of economic output singlehandedly. Yet it would obviously not be considered a recessionary meltdown without a “decline in economic activity that spreads across the economy.” For example, the US economy was officially in a mild recession after the burst of the dot-com bubble, but the GDP never fell in the recession year 2001.
Moreover, the quarterly GDP is subject to revision as while the GDP contracted by an annual rate of 1.6%, the Gross Domestic Income (GDI) expanded by an annual rate of 1.8% in the first quarter. Such a spread between the two measures is rare, given both estimate the same metric vis-á-vis the national economic activity. Thus, it is highly likely that an upward revision in the GDP reveals that the US economy did not contract at all in the first quarter!
Lastly, while the jobless claims have increased lately, the number of unfilled job openings has consistently fallen from a record high late last year. And adding between 300,000 to 400,000 jobs a month in 2022, the unemployment rate – which typically should spike in a recessionary environment – is near a 50-year low, still declining despite inflation and consistent rate hikes. Hence, the argument for an ongoing recession is moot from an analytical perspective. But what about an imminent recession?
The answer is as complex as it is irrelevant. For the sake of argument against the anti-hawkish Fed critics, while I admit the economy is slowing down, the pace of the slowdown is not palatable. The existing home sales have notably dropped; the rent has ticked higher. The car sales are down, but the confounding shortage of microchips has skewed the indicator. How can we confidently claim that the fall in automobile sales is due to consumer restraint and not the lack of availability of cars on sale? Despite a contraction in GDP (susceptible to future revision), consumer spending grew at an annual rate of 1.8% in the first quarter. The oil prices are still looming around $100/barrel, and the US strategic crude reserves have shown a worrisome drop in the last few weeks. The war in Ukraine is still flaring the global commodity prices, and Europe is visibly suffering from a debilitating energy crisis – relying on the US-supplied LNG to survive the winter. China is dealing with an unprecedented economic crunch which could eventually lead to convoluted supply chain snarls for the US. We need to realize that the Fed policies cannot resolve these supply-side challenges of food/energy inflation. And thus, even if overdoing is a legitimate possibility that could lead to a devastating economic collapse, the Fed has no choice (or control) over its destiny but to hike interest rates in the hope of sustainable economic activity down the road.
At the expense of stating the obvious: even the most sage economists around the globe cannot definitively predict the timeline of an approaching (or ongoing) recession. But I believe the course of action by the Fed would still remain the same regardless of an acute awareness of the point of inception. We should realize that the ‘easy money’ injected during the pandemic ought to exit the system to avoid an entrenched inflationary sentiment similar to the 70s. Hiking taxes or cutting government spending cannot bring about a timely shift in the inflationary profile of any country. And the US economy cannot afford to lose any more time. Hence, even at the cost of being cast in a villainous persona, the Fed is the only game in town capable of guiding the economy out of uncertainty – though probably not unscathed.