Maybe a mild recession wouldn’t be so bad at this point

As the Federal Reserve continues to raise interest rates to slow inflation, most people are wondering whether the U.S economy will go into recession. The hope is that the Fed does what it hasn’t done before: Fine tune the economy carefully enough that it engineers a so-called soft landing.

We can all dream, but maybe a recession would not be so bad.

For the Fed, price stability is Job 1. Why is the Fed concentrating so much on inflation? Former Fed Chair Alan Greenspan probably best explained the reason this way: “For all practical purposes, price stability means that expected changes in the average price level are small enough and gradual enough that they do not materially enter business and household financial decisions.”

When inflation is not under control, businesses and households are concerned with protecting themselves from rising prices, not how to operate most efficiently.

Indeed, if inflation is elevated, ultimately, everyone could suffer. As current Fed Chair Jerome Powell has noted: “Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all.”

Let’s also not forget that moderating inflation does not mean prices fall. We still pay the high prices for most goods and services; the costs just go up more slowly.

Sometimes, such as now, inflation is way too high. Because the Fed is tasked with price stability, its job is to slow things down. That is done through raising interest rates to reduce demand for things such as houses, vehicles and capital goods. When borrowing drops, spending drops, the economy slows, and price pressures fade.

Unfortunately, no one really knows how slow things need to get to moderate inflation. Do too little and inflation remains too high, causing pain across many segments of the economy. Do too much and you whip inflation, but the economy usually winds up in recession.

What is a recession? The shorthand but incorrect version is two consecutive quarters of negative economic growth. If that were the case, the economy would have been in recession during the first half of 2022, when growth declined in the first two quarters.

Instead, recessions are determined by the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), a private, nonprofit, nonpartisan economic research organization. Monthly data that provide a broad-based view of the economy are reviewed to determine the “depth, diffusion and diversity” of any downturn.

Should we fear a recession? Not necessarily. A recession can last as little as two months, as it did in the early portion of the pandemic, to 43 months, as it did during the Great Depression.

Recessions can be mild. The 2001 recession, which lasted eight months, led to a relatively modest rise of 1.5 percentage points in the unemployment rate and almost no decline in GDP. Nevertheless, inflation dropped sharply in that short period of time.

Though the Fed cannot control the type of recession it might create, a recession does not have to be catastrophic, and it would still reduce inflation.

That brings us to the point of why we might need a mild to moderate recession now. For the last two years, inflation has been running well above the Fed’s target of 2% over time. Indeed, last spring, inflation hit its highest pace in 40 years, and the latest Consumer Price Index reading was three times the Fed’s target.

Yes, inflation is coming down, but much of that was due to the unwinding of special circumstances, such as the massive rise in energy costs triggered by Russia’s invasion of Ukraine and the pandemic-induced supply chain problems that created sharp jumps in the prices of a variety of products.

Those increases were going to decelerate even without a major softening in the economy, and they have.

But the rise in inflation of most other products is linked to continued strength in the economy in general and the labor market in particular. As strange as it may sound, the problem is that the economy is in too good a shape.

Despite somewhat slower growth, the unemployment rate is the lowest in more than 50 years, job creation remains robust. There are nearly two job openings for every person unemployed. Put simply, the labor market remains extraordinarily tight.

And with tight labor markets come rising wages. And with rising wages come rising production costs. And with rising production costs come rising prices.

And with continued high inflation comes the need for the Federal Reserve to slow the economy down even more by raising rates further. Over the last 12 months, the Fed has pushed up short-term rates 4.5 percentage points, the fastest increase in more than 40 years. But as of January, inflation remains well above the Fed’s 2% target.

Which gets me back to my basic point. Currently, we have too much of a good thing, and that good thing is a stronger than expected economy, solid job growth, rising wages, growing consumer spending and consequently higher than desired inflation.

The Fed has a lot more work in front of it to reduce inflation significantly. Given Chair Powell’s promise to make sure price stability returns, just slowing growth may not be good enough. The Fed may be forced to raise rates longer and higher than expected.

If that happens, the resulting recession could be a lot steeper than if the Fed stopped trying the create the mythical soft-landing and focused strictly on reducing inflation now.

Sometimes, wanting perfect Fed policy may get in the way of good Fed policy and the consequences could be ugly.

Joel L. Naroff is the president and founder of Naroff Economics consulting firm in Bucks County.