A recession that drives inflation back to its target range could be deep, painful, and inevitable.
A recession that drives inflation back to its target range could be deep, painful, and inevitable.
F or those who follow closely the Atlanta Fed’s invaluable GDPNow estimate, today’s 4.9 percent real annual growth rate for the third quarter was a slightly negative surprise, as the mavens in Atlanta expected the number to be north of 5 percent. But for virtually everyone else who has been dining on a steady diet of “soft landing” rhetoric from Fed watchers, it was a major upside surprise. So, what’s going on?
The bottom line is that there are two parts to the story, one short run and transitory and the other long run and a major factor for the outlook into next year.
First on the short run. In the third quarter, consumers went absolutely nuts, with an increase in consumption adding 2.69 percent to GDP growth. That’s right. If everything else hadn’t moved at all, GDP growth would have been a healthy 2.69 percent just because of consumers. Why have consumers been able to keep binging even when real incomes, according to the Census Bureau, have been declining? The biggest part of the story is that the massive Covid subsidies were mostly placed in savings accounts rather than spent at the time, what with people being locked in their houses and all. Even as prices have risen faster than incomes, real consumption has been able to soar because people have had so much money in excess savings.
The bad news for the near-term outlook is that this excess Covid savings have been just about fully depleted. In a fascinating article, Bloomberg’s Alexandre Tanzi took the latest Fed data and used them to break out the path of excess savings by consumers in different parts of the income distribution. In March 2021, consumers in the bottom 40 percent of the income distribution had 5.7 percent more savings in their accounts than they did at the start of the pandemic. Individuals in the 40th to 80th percentiles had 14.8 percent more savings than they did at the start of the pandemic, and those in the top 20 percent had a whopping 28.1 percent. But by June, the Fed data reveal, the excess savings were fully depleted for everyone in the bottom 80 percent. Not only that, everyone outside the top 20 percent is worse off now than they were at the start of the pandemic. It seems almost impossible for consumption to continue to surprise on the upside.
But there is a longer-run story that cannot be ignored. Online calculators that draw on the seminal work of economist John Taylor to estimate the “Taylor Rule” value for the federal funds rate suggest that the Fed would need to lift rates another percent or two if it truly wanted to slay inflation. If the Fed keeps rates too low, then the economy will not slow enough to push inflation down, and growth and inflation will “surprise” on the upside until the Fed gets serious. A sign that exactly this type of force is present in the latest release is the estimate of the inflation rate from the implicit price deflator for GDP. In the second quarter, inflation optimists pointed to the 1.68 percent inflation rate in the GDP release as a sign that the Fed had accomplished its goal of stabilizing inflation. Inflation in the third quarter jumped all the way up to 3.5 percent and may well be accelerating above 4 percent in the current quarter.
Putting the two stories together, expect consumption to level off as consumers find themselves financially strapped, but also expect unemployment and wage growth to remain robust enough to keep inflation well above the 2 percent target. If it plays out that way, we will be entering the final stages of the stagflationary cycle I wrote about last year. Wage growth has inched above price growth, which is a pleasant thing for consumers but a disaster for profits. As equities wake up to the bad news and interest rates magnify the pain while inflation stays stubbornly high, the recession that drives inflation back to its target range will be deep, painful, and inevitable.
This all could happen quite quickly, but if the Fed continues to watch and wait, then the momentum from still-stimulative monetary policy should carry into next year. When it comes to inflation, the Fed will eventually have to be pure — but, like St. Augustine, not yet.