The writer is the founder of Sahm Consulting and a former Federal Reserve and White House economist
Some commentators argue that the United States needs a recession to bring inflation down. This thinking is based on a simplistic model of the economy and a refusal to see Covid and the war in Ukraine as major sources of inflation now. The stakes are too high to rely on such a questionable approach.
Yes, inflation is a hardship, and it hits those who have the least hardest. Among American families in the bottom 20% by income, nearly 60% of their spending is on food, gas and shelter. This is a much larger fraction than in high-income families.
The prices of these basic necessities have risen rapidly since the start of the pandemic. As a result, families with the lowest incomes spend on average more than $300 more per month to buy the same amount of these basic necessities.
Even so, a recession is worse than inflation. A lost paycheck or even lost hours would far exceed the additional monthly costs due to inflation. And the risk of losing your salary is not the same for everyone. According to research by economist Hilary Hoynes and her co-authors, during a recession it is generally higher for men, black and Hispanic workers, younger workers, and less educated workers. The adverse effects on the unemployed last for years. There is too much to lose with a recession, especially now.
The unemployment rate in the United States is 3.6%, near its lowest level in 50 years. More than 450,000 new jobs per month have been created on average since the start of the year. Total compensation for all employees has increased by 15% since the start of the Covid recession, two percentage points more than inflation. In contrast, after the Great Recession, inflation outpaced earnings.
So why do commentators need a recession? The labor market is too good and inflation will only come down if millions of people lose their jobs. A model developed in the 1950s called the Phillips Curve predicts that when unemployment rises, people earn less and spend less. Demand falls faster than supply and inflation falls. The higher the inflation, the more a recession is necessary according to the model.
There are many problems with this prescription. First, while the Phillips curve is intuitive, since the 1970s data has looked more like a cloud than a curve. In other words, there is a weak, if any, relationship between real unemployment and inflation. Economists disagree on what “killed” the Phillips curve, but it is widely accepted that it alone is inappropriate for policy-making.
Then there is another problem with the view that we need a recession. It depends on inflation, which is demand-driven. Specifically, its proponents attribute the inflation to the additional demand caused by the US bailout stimulus package and the Federal Reserve’s low interest rates last year. This is important because the Phillips curve only makes sense if inflation is demand-driven.
Once again, this argument clashes with reality. Ongoing Covid disruptions and the war in Ukraine are also driving up inflation. Adam Shapiro, an economist at the Federal Reserve Bank of San Francisco, estimates that less than a third of monthly core inflation, which excludes food and energy, is due to demand. Moreover, monthly underlying inflation has already fallen significantly this year. It remains too high, but progress is evident. It is fitting that the Fed is raising rates now. It would be a big mistake to cause a recession – and it is not intentionally attempted to do so.
Moreover, there is no rising unemployment rate that would produce microchips for new cars, end China’s lockdowns, defeat Vladimir Putin, drill for oil, and build apartments. The Fed raises interest rates and reduces demand, which cools the labor market. Whether it inadvertently triggers a recession or not, an interest rate hike would not solve supply problems and would likely aggravate some by discouraging investment.
Congress should also help dampen inflation. For example, it could pass legislation to keep health insurance premiums low, reduce rates, build affordable housing, and fund sustainable energy production. Only a handful of measures would quickly reduce inflation, but they would all pay off in the years to come and make the US economy more resilient to the next crisis.
We must aim to protect workers and their families and bring down inflation. These two goals need not be in tension, but it will take more than outdated rules of thumb and a misunderstanding of our economic challenges to achieve both. We need many things today; a recession is not one of them.