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The Federal Reserve and Recession Fears


Inflation is rampant, the Federal Reserve seems prepared to raise interest rates even higher than previously expected, financial markets are reeling, and rumors of recession are in the air. All of this signals economic pain ahead, and how much pain will depend on whether Washington avoids more of the policy mistakes that got us into this mess.

***

A recession is by no means certain, especially with a strong job market and consumers still flush from pandemic government payments. But inflation is sapping consumer confidence, with the Michigan sentiment survey falling to 50.2 in June from 58.4 in May, and from 85.5 a year ago. The more consumers believe that their real earnings will keep falling, the less they’ll spend to keep the economy afloat.

Business confidence has also fallen sharply. The small business NFIB Optimism Index fell again in May, and owners expecting better conditions in the next six months hit a net negative 54%. That’s the lowest in the history of the 48-year-old survey.

The grandees of the Business Roundtable aren’t feeling much better. CEO expectations for the next six months registered the sixth largest decline in the history of its Economic Outlook Index.

This is what the uncertainty wrought by inflation does to an economy. Companies feel flush at the onset of inflation as nominal earnings rise. But the euphoria fades as component costs rise, workers demand higher wages, and consumers begin to balk at more expensive goods and services.

None of this is an argument for the Federal Open Market Committee to ease up on its appointed monetary tightening this week. The Fed leaked Monday that the FOMC might consider a 75-point rate increase, and financial markets tanked on the news. But at 1% the real fed-funds rate is still deeply negative, and the Fed’s mistake is that it has been too easy for too long. The sooner the Fed breaks inflation, the better.

As

Mickey Levy

and

Charles Plosser

argue nearby, the Fed will probably have to go much higher to get inflation back to its 2% target. One sign to watch Wednesday is how much higher the FOMC eminences raise their expectations for the endpoint of rates than their 2.8% median in March.

This inevitably means tighter credit conditions. Fed Chairman

Jerome Powell

has all but said that the goal of the current tightening is to reduce demand in the economy and ease the tight labor market. This means slower growth, which was already underwhelming at minus-1.4% in the first quarter and is on a paltry 0.9% pace in the second quarter, according to the Atlanta Fed’s GDPNow tracker.

Tighter money and the risk of recession should also cause the White House to abandon its anti-growth fiscal and regulatory agenda. A slowing economy doesn’t need a $1 trillion tax increase, yet Senate Majority Leader

Chuck Schumer

is still trying to persuade Sen.

Joe Manchin

to sign on to a smaller version of Build Back Better.

The bizarre claim is that a tax increase will somehow reduce inflation. But the main effect of a tax increase would be to reduce investment and further restrict supply, which would arguably make inflation worse.

Democrats tried the tax increase to break inflation in the late 1960s but prices kept rising. They raised taxes in 1993 in the name of lower interest rates, but the Greenspan Fed still had to raise interest rates in 1994. The only way a tax increase would reduce inflation today is if it triggered a recession.

Businesses and consumers worried about rising costs also don’t need new regulatory burdens, which the Biden Administration is adding willy-nilly. A prudent White House would be calling for a regulatory moratorium, especially on domestic energy production.

***

The economic point is that policy makers should be pursuing pro-growth fiscal, deregulatory and trade policies to offset the impact of tighter money. That was the

Ronald Reagan

Paul Volcker

formula that broke inflation in the 1980s and led to a boom.

We realize that the White House isn’t likely to take this advice. Even as growth slows and markets slide, Mr. Biden spent Tuesday shouting to the AFL-CIO that more government spending and higher taxes on the wealthy are the cure for inflation.

But we don’t want a recession on any President’s watch, any more than Americans wanted the inflation that is killing Mr. Biden and his party in the polls as the midterm elections near. We’re here to help, Mr. President, but the Lord also helps those who help themselves avoid recession.

Wonder Land: The White House now says the U.S. economy is ‘in transition.’ They got that part right. Images: Getty Images/The Universal Archive via AP Composite: Mark Kelly

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