Why does good news about the economy sound bad to the Fed?

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Why does good news about the economy sound bad to the Fed? The complicated reason why could push us into a recession.

Many analysts and forecasters anticipate that a recession will land next year. Yet month after month, data piles up showing solid, if slowing, jobs growth, low unemployment and an expanding economy.

“You don’t get recessions in the U.S. economy until consumer spending slows, businesses respond with cost-control measures and that includes some layoffs,” said Stephen Miran, a co-founder of Amberwave and a former Treasury official. And so far, that hasn’t happened. In fact, layoffs remain below pre-covid levels.

So, if economic indicators are strong, why is the conventional wisdom that a recession is likely next year?

It all comes down to inflation and the Federal Reserve’s response to it. The Fed seems like it’s willing to at least countenance a substantial reversal in the labor market — more layoffs, higher unemployment — if not outright trying to cause one. That’s because the Fed’s overwhelming goal is to lower inflation, and its go-to tool to do that is slowing down the labor market by raising interest rates.

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Despite multiple reports showing inflation slowing, including one early this week that showed virtually no inflation in the past month, the Fed remained steadfast on Wednesday that it needed to take further steps still, raising interest rates another half a percent.

“The labor market continues to be out of balance, with demand substantially exceeding the supply of available workers,” Fed Chair Jerome Powell said in a press conference Wednesday. In other words, the Fed thinks wages are still growing too fast for inflation to come down from about 7 percent — what it’s been in the last year — to closer to 2 percent.

And the effects of the Fed’s interest rate hikes may be felt soon across the economy.

“The Fed is saying that even if they don’t get to as high of a terminal rate, there’s still likely to be lagged effects from the tightening already in place,” said Michael Gapen, head of U.S. economics at Bank of America and a former Federal Reserve economist. “I’m listening to what the Fed is saying; they’re saying we want to slow the economy now,” Gapen said. “They’re raising rates to slow down the economy and reverse imbalances in the labor market. Historically when we do that, we end up with some recession 12, 18 or 24 months later.”

Why good news seems like bad news

While aspects of the inflation picture are starting to slow and reverse — and many analysts expect house prices to decrease — the Fed has fixated on the rising costs of services that aren’t housing.

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Take, for example, the price of restaurant meals, which have gone up 8.5 percent in the last year, according to the Bureau of Labor Statistics. The largest component of that increased price is labor. Overall employment in the restaurant sector has still not returned to where it was pre-pandemic, meaning that workers who have come back can demand higher wages. With overall wages still rising by about 5 percent on an annual basis, the Fed sees little chance of inflation falling without continued action.

For much of the period between the Great Recession and the covid pandemic, a common complaint was that wages were growing too slowly. Now, according to the Fed, the paychecks of workers in the service industry are spurring on inflation. The Fed argues too that many workers are actually worse off due to the increase in prices eating away what gains they’re getting in wages.

These services, Powell said Wednesday, are “really a function of the labor market,” meaning that whether they rise or fall in price, or how fast they rise in price, depends on whether the wages of the workers providing them go up quickly or slowly.

“There’s an expectation … that the services inflation will not move down so quickly, so that we’ll have to stay at it so that we may have to raise rates higher to get to where we want to go. And that’s really why we are writing down those high rates and why we’re expecting that they’ll have to remain high for a time,” Powell said.

According to economic projections released Wednesday by the Fed, interest rate hikes will likely continue early into next year and that unemployment rate could rise almost a point to 4.6 percent.

“Normal” recessions

Gapen’s team at Bank of America estimates that unemployment could rise as high 5.5 percent, which he noted would still be around the average unemployment of the last quarter century and only a “mild” recession.

“We haven’t had one of these ‘normal business cycle recessions’ in some time,” Gapen said. “‘We’re not calling for a major decline in the economy; we’re not looking at the risk of a financial crisis.” Past recessions have been caused by massive shocks — the financial crisis of 2007-2008 or the arrival of the covid pandemic — while many past business cycles have been dominated by the Fed, Gapen explained: “It would be more akin to some other business cycles of prior decades where Fed put brakes on the economy for a period of time due to high inflation.” In this case, the Fed also has the ability to revive the economy more quickly, by cutting rates. “It doesn’t seem like there are catalysts for a bigger downturn,” Gapen said.

What to look for

The recession, if it comes, probably isn’t happening this year. For a recession to truly kick in, there would have to be a substantial change in economic conditions. This would likely happen with an interplay between declining prospects leading companies to start laying off workers in large numbers and even for smaller businesses to close up shop entirely, Miran said.

“That’s a terrible human cost and a horrible pain inflicted on the economy and lots and lots of households,” Miran explained. This contraction in businesses hiring and increase in layoffs could be sparked, Gapen said, by a downturn in consumption.

But right now, Miran said, “The key to believing that we’re in a recession is that the economy is going to experience large-scale job losses. Generally speaking so far, they haven’t really been widespread. You need much more to be a real recession.”

Thanks to Lillian Barkley for copy editing this article.

  • Matthew Zeitlin
    Matthew Zeitlin

    Domestic Economics Reporter

    Matthew Zeitlin is an economics reporter at Grid focused on the domestic impact of major stories such as coronavirus, the supply chain and economic volatility.