Although US employment remains strong, the rapid increase in Fed-imposed interest rates coupled with historically high inflation and supply chain issues combined to restrict growth in the US to levels consistent with recession. The Fed is attempting to tamp down demand by increasing the cost of borrowing and tightening liquidity. However, demand is already at levels that have produced two quarters of negative real growth in 2022. The Fed has taken the position that further economic contraction may be required before economic forces combine to drive inflation back to the 2% level that it seeks. Some analysts believe the recession is already here. Others argue that unemployment is too low to consider this to be a recession even though employment is a lagging indicator. Two facts are indisputable: real growth is much too low for a healthy economy, and inflation is much too high.
A large part of the challenge faced by monetary policymakers lies in the fact that the dominant characteristic of the current situation—high inflation—has not been primarily caused by excess demand. Instead, current high inflation is, in large part, the product of a series of supply shocks. The Russian invasion of Ukraine cut supplies of wheat, fertilizer, soybeans, and gas. The West’s response to that invasion cut off energy exports from Russia, leading to shortages that pushed gas and oil prices to new highs. Frequent COVID lockdowns in Chinese port cities constrained the flow of parts and finished goods from the world’s leading manufacturer. Our own experience with COVID and its lockdowns disrupted key elements of our domestic supply chains and negatively impacted participation in our domestic labor markets. The result of downward pressures on supplies was higher prices, and hence, inflation.
Another contributor to the current inflation was the extraordinary policy response to the COVID pandemic. We certainly cannot begrudge assistance to those that needed it in the face of such an unusual threat. But the serial assistance and loan programs, coupled with an aggressively expansionary monetary policy at the Fed, had the effect of introducing trillions of new dollars into the economy at a time when real productivity was at a low. Total stimulus, including both fiscal and monetary actions, totaled as much as $5–7 trillion. From a monetary perspective, some part of the present high inflation can be attributed to the extraordinary expansion of the money supply at a time when productive growth could not absorb it. A classic cause of inflation is when the money supply expands faster than productive economic growth.
To address the current situation, the Fed has two primary tools: interest rates and “quantitative tightening.” Quantitative tightening is the reverse of “quantitative easing” and is the process of reducing the vast portfolio of bonds the Fed holds on its balance sheet in an effort to mop up excess cash in the financial system. Quantitative easing involves creating new money to purchase bonds in the open market. It has the effect of flooding the financial system with new money. The Fed used quantitative easing to stimulate the economy in the aftermath of the Financial Crisis and during COVID.
Quantitative tightening is the opposite process of reducing the portfolio of bonds held by the Fed and draining excess money from the economy. The Fed is presently using both rate increases and quantitative tightening aggressively. Currently, the Fed is allowing $60 billion in treasuries and $35 billion in agency bonds which it holds on its books to mature without replacement every month. It is thereby reducing its holdings in bonds by those amounts each month. The process effectively removes an equal amount of cash each month from the US money supply.
Quantitative tightening will be effective in removing some excess cash from the financial system, thereby removing one monetary driver of inflation. Higher interest rates can tamp down demand by making purchases and investments more expensive. However, neither of these actions directly address the supply constraints responsible for so much of the current inflationary cycle. The Fed is using the tools that it has, even though those tools may be poorly adapted to fix the type of inflation from which we suffer. Because those tools may only indirectly address one of the root causes of the present inflation—supply constraints—they risk doing greater damage to overall economic growth than might otherwise be necessary. This is not entirely intentional; they are simply using the tools that they have. The Fed may be further motivated by the nature of the data it is focused on. It is attaching considerable importance to lagging indicators, such as the Consumer Price Index (CPI) and the unemployment rate. It rarely mentions leading indicators, such as durable goods orders or new building permits, which already suggest growth is decelerating.
Policymakers often overshoot in both directions, with stimulus when they perceive threats to the economy and with aggressively higher rates and a tighter money supply when inflation rears its ugly head. Very often their focus is on more concrete but lagging indicators, and it is not unusual for them to “double down” before the economy can fully react to their corrective measures. Investors and business leaders should anticipate that the probabilities of recession have increased in recent weeks, in part because the corrective measures have been so aggressive.
Source: U.S. Bureau of Economic Analysis, fred.stlouisfed.org