The truth is, we don’t know. But let’s be clear: whether we are or not doesn’t depend on the 2nd quarter GDP report. Though two consecutive quarters of declining GDP is often cited as the definition of a recession, it’s not the definition economists use. And with good reason.
Instead, the NBER Business Cycle Dating Committee uses this definition: “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” And they explain why GDP is not their preferred measure, which includes several reasons but this one seems most germane to our current moment: “[the] definition includes the phrase, ‘a significant decline in economic activity.’ Thus real GDP could decline by relatively small amounts in two consecutive quarters without warranting the determination that a peak had occurred.”
If not GDP, what do they look at? I’ll get into more detail later, but in short, they look at monthly measures of income, consumption, employment, sales, and production (a direct measure of production, which GDP is not — it’s a proxy).
However, the American public seems convinced that we are in a recession. The most recent poll I can find on this is from mid-June, which is useful because (as we’ll see below) we have most of the relevant measures of the economy for June 2022 already. In that poll, 56% of Americans say we are in a recession. And while there is some partisan bent to the responses, even 45% of Democrats seem to think we are in a recession. For those that say we are in a recession, 2/3 cite inflation as the primary indicator that we are in a recession.
Already here we can see the difference between the general public and NBER: the rate of inflation is not one of the measures that NBER considers when defining a recession. So, what are the measures they use?
We are living in volatile times. With covid-19, big federal legislation packages, and the Ruso-Ukrainian conflict disruptions to grain, seed oils, and crude oil, relative prices are reflecting sudden drastic ebbs of supply and demand. I want to make a small but enlightening point that I’ve made in my classes, though I’m not sure that I’ve made it here.
Economists often get a bad rap for being heartless or unempathetic. Sometimes, they are painted as ideologues who just disguise their pre-existing opinions in painfully specific terminology and statistics. Let’s do a litmus test.
Consider two alternative markets. One is a perfect monopoly, the other has perfect competition. All details concerning marginal costs to firms and marginal benefits to consumers are the same. In an erratic world, which market structure will result in greater price volatility for consumers? Try to answer for yourself before you read below. More importantly, what’s your reasoning?
Extreme Market Power
A distinguishing difference between a competitive market and a monopoly concerns prices. While firms maximize profits in both cases, the price that consumers face in a competitive market is equal to the marginal cost that the firms face. There is no profit earned on that last unit produced. In the case of monopoly, the price is above the marginal cost. Profits can be positive or negative, but the consumer will pay a price that is greater than the cost of producing the last unit.
Below are two graphs. Given identical marginal costs of production and benefits that the consumers enjoy, we can see that:
The monopoly price is higher.
The monopoly quantity produced is lower.
But static models only go so far. What about when there is volatility in the world?
Oil and gasoline are important inputs for producing many (most?) physical goods. Not only that, they are short-lived, meaning that they disappear once they are used, making them intermediate goods. Therefore, changes in the price of oil constitutes a change in the marginal cost for many firms. If the price of oil rises, or is volatile otherwise, then which type of market will experience greater price and quantity volatility?
Below are two figures that illustrate the same change in the marginal cost. We can see that:
Monopoly price volatility is lower (in absolute terms and percent).
Monopoly quantity produced volatility is lower (in absolute terms, though no different as a percent).
The take-away: While monopoly does constrict supply and elevate prices, Monopoly also reduces price and output volatility when there are changes in the marginal cost.
That covers the costs. But what about volatile demand? A large part of the Covid-19 recession was the huge reallocation of demand away from in-person services and to remote services and goods. What is the effect of market power when people suddenly increase or decrease their demand for goods?
Below are two figures that illustrate the same change in demand. We can see that:
Monopoly price volatility is higher (in absolute terms, though no different as a percent).
Monopoly quantity produced volatility is lower (in absolute terms, though no different as a percent).
Monopolies Don’t Cause Inflation
Economists know that inflation can’t very well be blamed on greed (does less greed beget deflation?). Another problematic story is that market concentration contributes to inflation. But the above illustrations demonstrate that this narrative is also a bit silly. Monopolistic markets cause the price level to be higher, it’s true. But inflation is the change in prices. Changing market concentration might be a long term phenomenon, but can’t explain acute price growth. If demand suddenly rises, monopolies result in no more price growth than perfectly competitive markets. If the marginal cost of production suddenly rises, monopolies result in less price growth.
All of this analysis entirely ignores welfare. Also, no market is perfectly competitive or perfectly monopolistic. They are the extreme cases and particular markets lie somewhere in between.
Did you guess or reason correctly? Many econ students have a bias that monopolies are bad. So, in any side-by-side comparison, students think that “monopolies-bad, competition-good” is a safe mantra. But the above illustrations (which can be demonstrated mathematically) reveal that economic reasoning helps to reveal truths about the world. Economists are not simply a hearty band of kool-aid drinking academics.
On May 6, 2022, the governor of Florida, Ron DeSantis, signed House Bill 7071. The bill was touted as a tax-relief package for Floridians in order to ease the pains caused by inflation. In total, the bill includes $1.2 billion in forgone tax revenues by temporarily suspending sales taxes that are levied on a variety of items that pull at one’s heartstrings. Below is the list of affected products.
A minor political point that I want to make first is that the children’s items are getting a lot of press, but they are only about 18.4% of the tax expenditures. The tax break on hurricane windows and doors received 37% of the funds and gasoline is receiving another 16.7%. There are ~$150 million in additional sales, corporate, and ad valorem tax exemptions. Looking at the table, it seems that producers of hurricane windows and doors might be the biggest beneficiary and that that the children’s items are there to make the bill politically palatable. Regardless, this is probably not the best use of $1.2 billion.
There are at least three economic points worth making.
The all items index increased 8.6 percent for the 12 months ending May, the largest 12-month increase since the period ending December 1981
Then this Wednesday the Fed announced they were raising interest rates by 0.75%, the biggest increase since 1994, despite having said after their last meeting that they weren’t considering increases above 0.5%. I don’t like their communications strategy, but I do like their actions this month. This change in the Fed’s stance is one reason I think we’re at or near the peak.
Its not just what the Fed did this week, its the change in their plans going forward. As of April, the Fed said the Fed Funds rate would be 1.75% in December, and markets thought it would be 2.5%. But now the Fed and markets both project 3.5% rates in December.
The other reason I’m optimistic is that the days of rapid money supply growth continue to get further behind us. From March to May 2020, the M2 and M3 supply exploded, growing at the fastest pace in at least 40 years:
Rapid inflation began about 12 months later. But the rate of money supply growth peaked in February 2021, then began a rapid decline. Based on the latest data from April 2022, money supply growth is down to 8%, a bit high but finally back to a normal range. Money supply changes famously influence prices with “long and variable lags”, so its hard to call the top precisely. But the fact that we’re now 15 months past the peak of money supply growth (and have stable monetary velocity) is encouraging. Old-fashioned money supply is the same indicator that led Lars Christiansen to predict this high inflation in April 2021 after successfully predicting low inflation post-2009 (many people got one of those calls right, but very few got both).
Stocks also entered an official bear market this week (down 20% from highs), which is both a sign of excess money no longer pumping up markets, and a cause of lower demand going forward.
Markets seem to agree with my update: 5-year breakevens have fallen from a high of 3.6% back in March down to 2.9% today, implying 2.9% average inflation over the next 5 years. Much improved, though as I said at the top the path to 2% will be a long one- think years, not months. Even the Fed expects inflation to be over 5% at the end of this year, and for it to fall only to 2.6% next year.
What am I still worried about? The Producer Price Index is still growing at 20%. The Fed is raising rates quickly now but their balance sheet is still over twice its pre-Covid level and is shrinking very slowly. The Russia-Ukraine war drags on, keeping oil and gas prices high, and we likely still have yet to see its full impact on food prices. Making good predictions is hard.
While I’m sticking my neck out, I’ll make one more prediction, though this one is easier- Dems are in for a bad time in November. A new president’s party generally does badly at his first midterm, as in 2018 and 2010. But this time the economy will be a huge drag on top of that. November is late enough that the real economy will be notably slowed by the Fed’s inflation-fighting effects, but not so late that inflation will be under control (I expect it to be lower than today but still above 5%). Markets currently predict a 75% chance that Republicans take the House and Senate in November, and if anything that seems low to me.
It has been such a volatile couple of days in the markets that you hardly know where to focus. Friday’s inflation print was 8.6% (year/year), higher than expected and the highest in forty years, showing (yet again) that the Fed’s “transitory inflation” line was always just fantasy. Despite its glacial, foot-dragging pace of response to date, the Fed will need to raise short-rates (which they directly control) faster and farther than earlier planned. The Fed does not directly control long-term rates, but they influence them by buying and selling bonds on the open markets. For years, they have been buying bonds (driving interest rates lower), but they will have to stop that and maybe go the other way, being net sellers of bonds. This will make financing government deficits much more difficult.
Anyway, both short and long term rates have gone vertical in the past few days as markets price in all this, reaching levels not seen since the aftermath of the 2008 Global Financial Crisis:
Mortgage rates will likely march even further upward, increasing the monthly payments for most homeowners. At some point, this will deflate the housing market. Some of today’s eager new homebuyers who paid over asking price, assuming that housing only goes up, may be in for a rude awakening.
It seems like the only way to tamp down inflation is old-fashioned demand destruction. Stock market participants are starting to price in the dreaded R-word (recession). The plunging stock market has been in the news the last few days. Yes, it has dropped a lot, but shown on a five-year chart below it may not be so apocalyptic. It is dropping from ridiculously over-optimistic market highs at the end of 2021. We are still slightly above the pre-COVID peak:
If you are young and working, you should see lower prices as a buying opportunity. If you are making regular contributions to a savings plan in stocks (dollar cost averaging), your dollars are buying you more stocks. If you feel you must DO something, you could always rebalance your portfolio, shifting some funds into stocks from something else, to maintain a say 70/30 stock/bond portfolio. Peace…
People have expectations about the world. When those expectations are violated, they usually change their behavior in order to account for the new information (on the margin at least). Does unexpected inflation affect people’s behavior? Of course. William Phillips thought so (the famous version of the Phillips Curve assumes constant inflation expectations).
Macroeconomists often separate the world into reals and nominals. Sometimes we produce more and other times we produce less. Those are the reals. The prices that we pay and the money that we spend are the nominals. There is what’s sometimes called a ‘loose joint’ between reals and nominals. That is, they do not move in tandem, nor are they entirely independent. If the Fed suddenly slows the growth of the money supply, then economic activity growth might also slow – but not by the same amount. In the long run, reals and nominals are largely independent. Whether we have 2% vs 3% annual inflation over the course of some decade is probably not important for our real output at the end of that decade.
It Takes Two to Tango.
It is often said that the Fed can achieve any amount of total spending in the economy that it prefers. It can achieve any NGDP. But, the Fed doesn’t control NGDP as a matter of fiat. The Fed changes interest rates and the money supply in order to change the total spending in our economy. Importantly, the effect of Fed policy changes is contingent on how the public reacts. After all, the Fed can increase the money supply. But it is us who decides how much to spend.
My wife traveled to Ireland with a friend after she graduated with her bachelor’s degree. She had lived in Europe as a child and had travelled for mission trips. But travelling to the Irish Republic as a young adult, for the singular purpose of celebration and leisure, made a big impact on my eventual wife and she recounted it for years.
Remember pre-Covid when life was so easy? Many of us had planned trips, for business and leisure, that were interrupted. By now, the vast majority of people are back to ‘normal’ (I think?). Classes are in-person, masks are largely optional, and there is no more line stretching out down the sidewalk near the Trader Joe’s. With all this normalcy, one might ask:
In July of 1992, the Barenaked Ladies released their debut studio album Gordon, which included one of their most popular songs: “If I Had $1000000.” Considering all the inflation we’ve had recently, you know that $1 million doesn’t buy as much as it did in 1992, but how much less? As measured by the Consumer Price Index in the US, prices have roughly doubled since 1992, meaning you would need about $2 million to buy the same amount of stuff as in 1992.
(Note: the Barenaked Ladies are Canadian, and prices in Canada haven’t quite doubled since 1992, but this song was included on early demo tapes in 1988 and 1989 released in Canada, and prices have roughly doubled there since then.)
So the value of a dollar that you held since 1992 has lost roughly half of its purchasing power. That’s bad. But how bad is it? What’s the normal US experience for how long it takes for prices to double?
It turns out that even with the recent huge run-up in inflation, we just lived through the lowest period of inflation for anyone alive today.
The latest CPI inflation report didn’t have a huge surprise in the headline number, with 8.3% being very similar to last month. But with the two most recent months of data, we can now see something very unfortunate in the data: cumulative inflation during the pandemic as measured by the CPI-U (11.6%) has now almost matched average wage growth (12.0%), as measured by the average wage for all private workers. I start in January 2020 for the pre-pandemic baseline.
What this means is that inflation-adjusted wages in the US are no greater than they were before the pandemic. They are almost identical to what they were in February 2020 (just 2 cents greater). But as regular readers will know, the CPI-U isn’t the only measure of inflation, and there’s good reason to believe it’s not the best. One alternative is the Personal Consumption Expenditures price index. Cumulative inflation for the PCE is slightly lower during the pandemic (9.0%, though we don’t have April 2022 data yet).
This chart shows average wage growth adjusted with both of these different measures of inflation, expressed as a percent of January 2020 wages. The CPI-U adjusted wages (blue line) have been falling steadily since the beginning of 2021, though the declines have accelerated in 2022. The PCE-adjusted wages (orange line) have also not performed superbly, but at least they are still 2-3% above January 2020. Still, the picture is not rosy: they’ve basically been flat since mid-2020 and have started to drop in early 2022.
Of course, average (mean) numbers can be tricky and sometimes misleading. What if instead we used median wages? Unfortunately, there is no hourly median wage data that is updated every month. The closest data that I usually look at is median weekly earnings, which is available on a quarterly basis. Here’s what that data looks like, expressed as a percent of the first quarter of 2020. I limit the data to full-time workers, since that should give us a roughly comparable number to the hourly data (hours of work may have changed, but using full-time workers should make it roughly constant).
One final note: if we look at weekly earnings across the distribution, and not just at the median, we see something very interesting. Earnings at the bottom of the distribution seem to be performing better than those at the top. In fact, the 10th percentile weekly wage is the only category that is still above pre-pandemic levels. I’m only adjusting using the CPI-U here, but the patterns for the PCE-adjusted earnings would be roughly similar.
We should be cautious about interpreting this data too: if workers dropping out of the labor force are primarily at the bottom of the distribution, it will artificially push up the 10th percentile earnings level. It would be good to know how much of that is going on here. Still, I think this is an important result in the current data.
During the week of thanksgiving in 2020, our thirteen-year-old microwave bit the dust. NBD, I thought. Microwaves are cheap, and I’m willing to spend a little more in order to get one that I think will be of better quality (GE, *cough*-*cough*). So, I filtered through the models on multiple websites and found the right size, brand, and wattage. No matter the retailer, at checkout I learned that regardless of price, I’d be waiting a good two months before my new, entirely standard, and unexceptional microwave oven would arrive. I’d have to wait until the end of January of 2021.