Most recessions begin from a position where the economy is operating at close to its natural rate. Therefore, when we visualize recessions we tend to think of economies where output is depressed to a level well below its natural rate.
In principle, recessions could begin at any point in the business cycle. A recession could begin when the economy was already operating at well below potential, with the 1937-38 recession being the most famous example.
A recession could also begin from a position where the economy is operating well above potential, as in the case of the 1946 recession (and to a lesser extent 1969). In some recent blog posts, George Selgin provides a really insightful analysis of the post-WWII recession (here, here and here), which in many respects didn’t look much like a recession at all. For instance, unemployment remained low even as measured RGDP fell sharply (as wartime industries were unwound.)
This period is difficult to evaluate due to the distortions caused by the imposition of wartime price controls and their removal after the war, which artificially boosted measured RGDP during the war and artificially depressed growth after the war. It is difficult to accurately measure the value of war output that doesn’t sell at market prices.
In my view, a situation where the economy returns from a position of above potential back to the trend line is so different from an ordinary recession that another term would be appropriate—say “correction”. But I don’t get to make the rules, and I accept that the profession as a whole refers to this situation as a “recession”.
During this sort of period, you might expect output figures to look much worse than employment figures. That’s because when the economy is overheated, firms are not able to hire as many workers as they would like. There is a shortage of workers. Why don’t firms simply raise wages to eliminate the shortage? Because they are monopsonists in the labor market.
When the economy slows, firms will continue hiring workers for a period of time. You will see very weak RGDP growth numbers combined with very strong gains in employment. Sound familiar? As long as the economy merely returns to the previous trend line, unemployment need not rise to very high levels. It might look like a recession, but it won’t feel like one.
This has implications for monetary policy. Those of us that favor level targeting argue that the economy will be more stable if the Fed promises to return its target variable (prices or better yet NGDP) back to the previous trend line after a shock pushes it away from equilibrium. The Fed accepted this argument, but only for making up demand shortfalls, not offsetting demand overshoots. In 2020, they committed to make up the undershoot in inflation with higher than normal inflation in the future. But in late 2021 they refused to commit to offsetting an overshoot in aggregate demand with lower than target inflation in future years. That was the Fed’s key mistake. (BTW, supply-side inflation over or undershoots need not be offset under the Fed’s dual mandate.)
Why did they make this mistake? I’m not sure, but perhaps they confused economic corrections with garden-variety recessions. They might have assumed that if the economy had overheated, bringing aggregate demand back to the previous trend line would push us into recession. In a technical sense that might be true (depending on how sharp the adjustment), but it would be a recession utterly unlike anything we’ve experienced since 1946. A sort of painless recession.
To be sure, the Fed could very easily overshoot and create an ordinary (painful) recession, with output well below trend and high unemployment. Ironically, the Fed’s refusal to do symmetric level targeting makes that unfortunate outcome much more likely. With level targeting, monetary policy mistakes have less severe consequences, as market anticipation of future make-up policy corrections prevents demand from moving as far off course as otherwise. In other words, the Fed is making it hard on itself with its “let bygones be bygones” approach to stabilizing demand.
READER COMMENTS
David S
Sep 3 2022 at 7:32am
This was a helpful post, and happened to coincide with my completion of David McCullough’s biography of Harry Truman, so I think have a slightly better understanding of the immediate post-War period. In many respects, the Truman years were considerably more turbulent–both economically and politically than anything we’re experiencing now.
There’s a body of pundits right now who are rooting for a recession, which I find bizarre and disgusting. They seize on any data point to crow about the ongoing or imminent collapse of the stock market, manufacturing sector, energy sector, etc…
I like the term “correction” and intend to start picketing the NBER office next week to encourage them to expand their vocabulary.
Robert D.
Sep 3 2022 at 9:02am
Here is an anecdotal report from someone on the ground. I work for a company that manufactures goods used in various applications (infrastructure, building materials, plastics, packaging, autos, etc.). We have seen a significant worsening in market conditions in the past couple of months. This downturn is across the board in all segments of our business. Messaging from the executive wing has been approaching the level of concern they voiced when the pandemic started. Any expenses that aren’t required to maintain the safety are deferred until next year. Business travel requires convincing first and second-level managers for approval. Middle management is already working on headcount reduction plans.
Interestingly, my company is still hiring at a pace of about 25% slower than a few months ago. I want your take above to be what happens, but the current messaging from our executive team is very grim.
Scott Sumner
Sep 4 2022 at 1:06pm
“I want your take above to be what happens,”
Just to be clear, my take is not a prediction.
Spencer
Sep 3 2022 at 9:45am
re: “Why did they make this mistake?” It’s Nobel laureate Milton Friedman’s “Fool in the shower” metaphor.
The mistake was made in 1961. Banks aren’t intermediaries. Banks don’t lend deposits. Deposits are the result of lending. See: “Should Commercial banks accept savings deposits?” Conference on Savings and Residential Financing 1961 Proceedings, United States Savings and loan league, Chicago, 1961, 42, 43.
So, the demarcation that Powell referenced, Powell’s theory, “We have had big growth of monetary aggregates at various times without inflation, so something we have to unlearn.” occurred in 1981 (after the “monetization of time deposits”), the virtual end of gated deposits. An increase in saved bank deposits reduces the velocity of circulation. An increase in the volume or percentage of saved demand deposits shrinks R-gDp.
Regardless of whether we experience a recession, we still deal with secular stagnation. And this is reflected in the Nov. 2021 end in the 240-year bull market (Elliott Wave Theory). The economy is running in reverse, with artificial demand (debt monetization).
Spencer Bradley Hall
Sep 3 2022 at 9:53am
The gap between gdi and gdp has been 3.5% larger than its gdp in 2022. N-gDp is still running too high. The FED needs to drain the money stock and simultaneously increase the velocity of circulation (the 1966 Interest Rate Adjustment Act).
Spencer Bradley Hall
Sep 3 2022 at 10:33am
And the FED ceased to be “pushing on a string” in 1942.
mkg
Sep 3 2022 at 2:41pm
The logic of the post is helpful. Applying this to early 2021, this implies the economy was operating above long term capacity (like perhaps 1969)? If so:
1. What objective measures would you look at to conclude the economy was actually operating above capacity? Just NGDP level over trend?
2. Subjectively, why do you think economy was over capacity? Since real output (gdp) in Jan 2021 was lower than Jan 2020, was there a loss of capacity for output (perhaps Covid labor issues)?
3. In #2 if there was a loss of capacity, and if the fed had followed level targeting policy as you suggest, would it end up looking like the fed was causing a recession, but in fact the fed was preventing an inflation and the underlying loss of output capacity was the real issue?
These questions doesn’t really affect your analysis but just curious how various underlying phenomena + policies would lead to possible perceptions on the outcome side.
Scott Sumner
Sep 4 2022 at 1:06am
mkg, #1. Mostly NGDP, but other indicators suggest that NGDP relative to trend understates the degree of overheating, as the trend growth in RGDP slowed significantly during Covid.
#2, No, the overheating occurred in late 2021, not early 2021.
#3 Just the opposite, If there’s a loss of capacity then NGDP level targeting results in overheating.
mkg
Sep 9 2022 at 9:31pm
perhaps that’s why the looming inflation got missed. Some of it was implicitly expected
Andrew_FL
Sep 3 2022 at 4:28pm
I don’t know if you saw my reply to your reply on your soft landing post, but I did link to unemployment data for 1940-46 which helps to clarify this “correction recession”
There was a one time increase in the 14yo and over unemployment rate in September 1945 which can be attributed to the demobilization from WWII, from 1.51% in August to 3.40%. from 1946-1948 unemployment wiggles around in a very narrow band between just under 3.5 and just over 4%, but is basically flat. Pretty clear that the war time rate is “artificially low”
Census used to report the household survey and when they did they reported the population level including armed forces as well as civilian population. I have hand transcribed the data myself from the old reports. From June 1945 to February of 1948 *10.9 million* left the armed forces to rejoin the civilian population. The unemployment rate difference between those dates was a mere 2.33 points.
Scott Sumner
Sep 4 2022 at 1:07pm
Thanks for that info.
Spencer Bradley Hall
Sep 4 2022 at 2:09pm
Steve Hanke: ““We will have a recession because we’ve had five months of zero M2 growth, money supply growth, and the Fed isn’t even looking at it,” Hanke told CNBC. “We’re going to have one whopper of a recession in 2023.”
Recessions aren’t a product of M2 growth rates. But since time deposits, a component of M2, originate within the banking system (and there is a one-to-one relationship between time and demand deposits — an increase in TDs depletes DDs by an equivalent amount), there cannot be an “inflow” of time/savings deposits and the growth of time/savings deposits cannot, per se, increase the size of the banking system.
From a system standpoint, TDs constitute an alteration of bank liabilities, their growth does not per se add to the “footings” of the consolidated balance sheet for the system.
Except for “Black Swans”, most recessions are caused by unrealized “leakages” in National Income Accounting procedures.
Even Divisia aggregates points to the large increase in DDs (means-of-payment money). Roc’s in DDs are still historically high (both short and long term). And Powell says innovation has skewed the aggregates: ““Now, we think more of just the imbalances between supply and demand in the real economy rather than monetary aggregates”
There’s just still too much money in the economy, as evidenced by M2/gDp. AD and thus N-gDp are still too expansive (not contractive).
marcus nunes
Sep 4 2022 at 6:43pm
Some of your arguments are illustrated in the pictures in this post. But, instead of a gradual, painless adjustment, the Fed says it wishes to impose some pain in the short term to avoid even greater pain!
https://marcusnunes.substack.com/p/the-eagle-has-landed
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