Are We There Yet? - May 1 2022

The numbers are in for the first quarter of 2022, and they don’t look particularly promising. 

Economists define a recession as two periods of negative growth. I always find that to be a funny term. Is negative growth the same as a positive shrinking? 

Seriously, folks, the first thing we must ensure is that we are calculating growth properly. We use the change in real Gross Domestic Product as the ruler. The gross domestic product is the amount of goods and services a nation produces domestically. Another way to calculate it is the value of goods and services bought or sold, adjusted for inflation. 

In other words, with inflation of 7% to 8% currently, we’d expect the value of stuff to grow by the same amount or more, for no other reason that the stuff is being sold at a higher price. So, the first thing we must do with our nominal GDP is to deduct inflation. 

Here is why we are having negative growth. Inflation is rising at 7% to 8%, but wage costs, which is by far and away the biggest cost to producers ultimately, is rising at only about 4%. That means people don’t have the additional purchasing power to pay for the same amount of stuff. 

Our nation has been addicted to excessive government spending that has put more money in our pockets than what we have earned for many years now as politicians have been lining up to buy our votes. The crack has stopped and we are no longer spending enough to keep the economy growing. 

The president says this is just a statistical blip. Of course, any such blip ahead of midterm elections is problematic, so we will see. 

However, the Fed had now publicly recognized that they have done too little too late to stem inflation, something this column has been saying for a year. Once we include the effect of rising interest rates to combat spending, GDP growth should decline even more. 

The rising interest rates discourage banks from using up any excess reserves they hold with the Federal Reserve by making commercial loans. With a shortage of loanable funds, commercial interest rates also float up. Just the belief that these rates will float up has a quick impact on interest rates. Borrowers want to get their projects funded under the wire before rates rise, but banks are even more reluctant to lend knowing that they will be holding assets paying a low interest rate when all other lending will soon be repriced at a high rate. Banks don’t want to be holding a low interest rate loan for ten years when they have to constantly replenish their loanable funds at higher interest rates. 

These forces combine to slow commercial lending, cool off construction, and even spread out into higher mortgage and car loan rates, whichreduces new home construction and car sales as people decide to keep their money in their back pockets. 

This is the classic mechanism the Fed relies upon to slow down aggregate demand and reduce inflation. It is the primary tool in the Fed’s toolbox since the Fed cannot do fiscal policy such as roadbuilding, etc. to stimulate demand, or taper it off when inflation occurs. The Fed is limited to monetary policy. 

The Fed is pulling pretty hard on that string. When their monetary tightening combines with inflation that is choking off spending power, it seems to me that we will also have another quarter of recessionary GDP declines. In fact, I don’t see this recession ending until the Fed can taper off its monetary tightening. 

This means stagflation. However, it is not up to me to decide. The National Bureau of Economic Research is a private group of economists that make the determination. They also look at the unemployment rate, which is very, and even artificially, low given the Great Resignation and the wave of early retirements. For instance, for our Canadian readers, their government expects 20% of the labor force to retire in the next ten years, with fewer young people to come up behind them. 

We may be in a very strange neverland. High inflation, low unemployment, higher interest rates, and a recession all at the same time. I know of no other time that this has happened. Mind you, we also suffered the first pandemic in a century (and still do to a degree), are assisting in the first major European conflict and mass outmigration since WWII, suffer fiscal policy that has been ridiculously incoherent for half a dozen years, and are in a monetary policy quagmire. 

Strange times, to say the least. Hold on to your hats.