Economist Joel Naroff: Can a recession be avoided?

Inflation is running rampant, gasoline prices are the highest ever, consumer confidence is fading, the equity markets look like roller coasters, mortgage rates are soaring, the Fed is raising rates, and there is a war in Ukraine. Oh, and I haven’t even mentioned COVID.

Should we be worried? Well, yes. The dreaded word “recession,” is now being tossed around.

Is a downturn inevitable? No, but we need a lot of luck to escape one.

First, the economy is doing just fine. Last year, it expanded at the fastest pace in nearly 40 years.

The labor market is roaring. Nearly 1.7 million new workers have been hired this year. The unemployment rate is near historic lows. Jobs are plentiful as there are nearly twice as many openings as unemployed people. Pay is surging. The average hourly wage increased 5.6% in the last year, one of the largest gains on record.

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But conditions are changing. Economic growth was driven largely by government stimulus funds. Whether it was assistance to individuals through expanded unemployment payments or to businesses through programs such as the Paycheck Protection Program, massive transfers of income, coupled with the reopening of the economy, caused growth to jump.

But no good deed goes unpunished. Ultimately, the government’s support system had to end, and for the most part it did last September. Workers and businesses are now on their own.

As for inflation, the government supported strong spending even as the economy reopened slowly. Supply failed to meet the surge in demand. Businesses saw an opportunity to raise prices in a way they couldn’t for decades, and inflation took off.

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But you cannot blame just the government for the high inflation. Yes, it helped start the fire, but our elected officials were in a difficult position. No one knew how long the pandemic would last, how bad it would be, and how deeply it would affect the economy.

Since failure to turn around the economy was not an option, the government did too much for too long. What should have been reduced? Household income supports? Business survival funding?

The government was not the only source of the inflation problem. The stimulus programs provided the demand, but supply was constrained by the pandemic and its impact on the global supply chain. Our economic partners also shut down and took their goods and services with them.

The tangled global supply chain is still a problem. It could take until well into 2023 before conditions start approaching normal.

And then there are energy costs. The pandemic shutdowns led to cutbacks in energy production. Domestic producers say that it is hard to increase supply quickly, even though demand has surged for two years now. Meanwhile, the Russian invasion of Ukraine has created chaos in the world energy markets, further pressuring prices. And OPEC is keeping supply down, as well.

As long as those factors persist, petroleum prices will remain high, increasing costs for households and businesses alike. There is little the government can do to change that.

Energy is not the only factor driving up prices. The massive excess of job openings has created a bidding war, where firms looking for employees are offering major wage increases to secure needed workers. As wages increase, business costs rise.

Since firms have pricing power, they are passing all those increased expenses through to their business and household customers.

This wage, cost, price cycle cannot continue, and the Fed, which is in charge of controlling inflation, finally recognizes that.

After saying inflation was “transitory,” the Fed woke up and did a 180-degree turnaround. It now believes that inflation is much too high.

And what does the Fed do when it believes inflation is getting out of control? It raises interest rates, which it started doing in March. It also indicated it could increase rates at least two percentage points this year and more next year.

The Fed’s intent is to slow demand. Interest-sensitive sectors, such as housing, vehicle sales and business investment, are the targets of the monetary policy tightening.

But it takes time for higher rates to work. For example, when mortgage rates start increasing, home buying tends to increase, not fall, as house hunters fear rates will rise further if they wait.

Meanwhile, inflation keeps accelerating, creating all sorts of problems.

For many households, the jump in prices of energy, food, and other essentials is devastating, as those costs are rising faster than incomes. Consumer purchasing power is declining, despite the wage gains.

The greater the burden inflation is on consumers, the more despondent they get. Consumer confidence has cratered. The University of Michigan’s closely watched index is below where it was at the peak of the pandemic. That says a lot.

Deteriorating confidence and falling spending power imply that consumer spending is likely to slow, possibly sharply.

Which brings us back to the Fed, which is intent on ridding the economy of high inflation. Can it engineer a “soft landing,” where rates are increased enough to slow growth, and therefore inflation, but not so much as to drive the economy into recession?

The Fed’s ability to accomplish this delicate task would be questionable even in more normal economic times. But we are not in normal times. The war in Ukraine, the reappearance of corporate pricing power, the reemergence of the ability of oil producers to control energy prices, the downshifting of government stimulus funding, the decline in consumer confidence and the divisive politics that make rational fiscal policy difficult all raise the odds of a recession.

The big thing the economy has going for it is its current solid condition, giving the Fed some room to err. Because it is impossible to know how much is enough when it comes to raising interest rates, that is good news.

A recession is not baked in the cake. But the best we have is hope the Fed can do the near-impossible, and we get a slowdown, not a downturn. Plan accordingly.