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.