We’re not in a recession, but we could be soon

There is a political debate over whether the US economy is in recession.

Republicans say that because gross domestic product, a key economic measure, has been negative for the past two quarters, it’s a recession. Democrats rightly point out that job growth is strong and defining a recession is not so straightforward.

But the debate misses an important point: there is a real risk of a recession, and whether that will happen is largely a decision of the US government. The Federal Reserve is raising interest rates to curb inflation, and there could be significant collateral damage.

“We’re not trying to have a recession,” Federal Reserve Chairman Jerome Powell said this week. “And we don’t think we have to.”

Higher rates make money more expensive to borrow, prompting individuals and businesses to spend less. This translates into lower overall demand for goods and services, which will hopefully prompt companies to lower their prices to woo more timid buyers.

A potential side effect of lower consumer spending is millions losing their jobs – but Powell doesn’t put it that way.

“If you translate Fed-speak into people-speak, it doesn’t sound very good,” Claudia Sahm, a senior researcher at the Jain Family Institute and former Federal Reserve economist, said in an interview with HuffPost.

Sahm praised Powell for communicating more to the public than his predecessors. But the language of the Fed is abstract. Powell says inflation is caused by an imbalance of supply and demand, with too much of the second and not enough of the first. Raising interest rates reduces demand, and this is how the Fed restores balance. It recognizes that achieving balance will involve a necessary “easing of labor market conditions.

The big question: how loose should the labor market be?

Powell said despite the contraction in gross domestic product, he doesn’t think the economy is in a recession because the job market is still going strong. The National Bureau of Economic Research, the official recession marker, says a recession involves “a significant drop in economic activity that spreads throughout the economy and lasts for more than a few months,” with a major impact on salaried employment.

The national unemployment rate is 3.6%, which is very low by historical standards. Many economists believe that when unemployment is too low it can cause inflation and that there is a “natural” rate of unemployment that does not cause inflation. If unemployment falls below the natural rate, the theory goes, then inflation rises because too many people are earning and spending.

Powell suggested at a press conference Wednesday that the natural unemployment rate is probably not 3.6% right now.

“It could be higher,” he said. “And my own instinct is that the natural unemployment rate is higher.”

Sahm said Powell was basically saying the actual unemployment rate Needs be higher. An estimate of the natural rate places it above 5%. “Going from 3.6 to 5? It’s a recession,” Sahm said.

Some economists, Sahm included, are skeptical that there is such a clear link between inflation and unemployment. And many have questioned whether the Fed should squash demand when supply chain issues — such as COVID lockdowns in China — are the main reasons for the supply and demand imbalance.

A reporter asked Powell on Wednesday what he would say to workers who may lose their jobs as higher interest rates dampen economic activity.

“I guess the first thing I would say to every household is that we know inflation is too high,” Powell said. “We understand how painful it is. Especially for people who live paycheck to paycheck and spend most of that paycheck on necessities like food and gas. And heat their homes. And clothes and things like that. We understand that these people suffer the most.

As for the job loss, Powell became abstract: “As I mentioned, there will, in all likelihood, be an easing of labor market conditions. We need growth to slow down to below-potential growth. We don’t want it to be bigger than necessary, but at the end of the day, if you think about the medium to long term, price stability makes the whole economy work. This is what can give us a strong labor market and wages that are not swallowed up by high inflation.

Sahm thought Powell’s response was frustrating.

“These paycheck to paycheck people are going to be the first to lose their jobs,” she said. “I wish they were a little more direct about what this is going to mean.”