A recession caused by the Fed is a medicine worse than a disease

The writer is founder of Arrow Consulting and a former economist at the Federal Reserve and the White House

Some commentators argue that the US needs a recession to bring down inflation. This thinking hinges on a simplified model of the economy and a rejection of seeing COVID and the war in Ukraine as important sources of inflation now. The stakes are too great to rely on such a questionable approach.

Yes, inflation is severe, and it affects the least severe. Among American families in the bottom 20 percent of income, nearly 60 percent of their spending is on food, gasoline, and housing. This is a much larger portion of high-income families.

Prices for these necessities have risen rapidly since the pandemic began. As a result, low-income families spend, on average, more than $300 extra per month to purchase the same amount of these necessities.

However, recession is worse than inflation. Losing a paycheck or even lost working hours will far outweigh the additional monthly costs due to inflation. And the possibility of losing a paycheck is not the same for everyone. according to Research From economist Hilary Hoenes and co-authors, recessions are typically higher for men, black workers, Hispanic workers, young workers, and less educated workers. The negative effects on the unemployed last for years. There is a lot to lose with a recession, especially now.

The unemployment rate in the United States is 3.6 percent, near its lowest level in 50 years. More than 450,000 new jobs have been created per month, on average, since the beginning of the year. Total compensation for all employees is up 15 percent since the start of the Covid recession, two percentage points higher than inflation. In contrast, inflation has outpaced the compensation rate after the Great Recession.

So, what’s the commentator’s case for the need to slack off? The job market is very good, and inflation will only go down if millions lose their jobs. A model developed in the 1950s called the Phillips curve predicts that when unemployment rises, people have less income and spend less. Demand falls faster than supply and inflation falls. The higher the inflation, the more severe the recession the model says is needed.

There are many problems with this recipe. First, while the Phillips curve is self-evident, data since the 1970s has looked more like a cloud than a curve. That is, there is a weak relationship, if any at all, between actual unemployment and inflation. Economists disagree with why the Phillips curve is “killed,” but it is widely understood that it alone is not suitable for policy making.

Then there is another problem with the “we need a slump” view. Depends on inflation being demand-driven. Specifically, its proponents blame inflation on additional demand caused by the US bailout stimulus package and low interest rates from the Federal Reserve last year. This is important, because the Phillips curve only makes sense if inflation is driven by demand.

Once again, this argument clashes with reality. The ongoing turmoil from the Covid virus and the war in Ukraine is driving up inflation as well. Adam Shapiro, an economist at the Federal Reserve Bank of San Francisco, Estimates Less than a third of the monthly core inflation, which excludes food and energy, is due to demand. Moreover, monthly core inflation has already fallen significantly this year. It’s still quite high, but progress is clear. It is appropriate for the Fed to raise interest rates now. It would be a huge mistake to cause a recession – nor is he trying to do so on purpose.

Moreover, there is no increase in the unemployment rate that would produce microchips for new cars, end of lockdowns in China, defeat of Vladimir Putin, oil drilling and apartment building. The Fed raises interest rates and lowers demand, calming the labor market. Whether it inadvertently causes a recession or not, higher interest rates will not solve supply problems and may even make matters worse by discouraging investments.

Congress should help dampen inflation, too. For example, it could pass legislation to keep health insurance premiums low, cut tariffs, build affordable housing, and fund sustainable energy production. Just a handful of measures would quickly bring down inflation, but they would pay off in the coming years and make the US economy more resilient in the next crisis.

We must aim to protect workers and their families and reduce inflation. These two goals don’t have to be on edge, but it takes more than outdated rules and a misunderstanding of our economic challenges to do both. We need many things today; Recession is not one of them.