By James Pethokoukis and Michael Strain

The Federal Reserve
recently announced a 75-basis-point rate hike—the largest since 1994—in an
attempt to curb inflation. The Fed’s aim is to thread the needle by cooling the
economy just enough to rein in rising prices without inducing a recession. But will
the Fed succeed, or is a recession on the horizon? And if an economic downturn
is coming, how severe will it be? To answer those questions and get a sense of
where the US economy is heading, I’ve brought my AEI colleague Michael Strain
back on Political Economy.

Mike is the director of Economic Policy Studies and the Arthur F. Burns Scholar in Political Economy at the American Enterprise Institute. He’s also the author of the 2020 book, The American Dream Is Not Dead: (But Populism Could Kill It).

What follows is a lightly edited transcript of our conversation, including brief portions that were cut from the original podcast. You can download the episode here, and don’t forget to subscribe to my podcast on iTunes or Stitcher. Tell your friends, leave a review.

Pethokoukis: Inflation is really high. How did we get
here?

Strain: We got here through
several factors. It won’t surprise you if I group those factors in two
categories: demand and supply. On the supply side, we had supply chain bottlenecks
that restricted the ability of businesses to produce goods and services. We had
a situation where it was hard for businesses to find workers, where the
workforce participation rate wasn’t recovering from the pandemic as rapidly as
people had thought. That was due to a variety of factors: concern about getting
sick, having to care for children whose classrooms were closed or elderly
relatives, things of that nature. It was due in part to pandemic-era programs
that expanded the generosity of unemployment benefits or that just expanded
household savings generally, which put workers in a position where they could
be a little choosier about which jobs they took than they normally would be. Idiosyncratic
factors like semiconductor shortages—all this sort of stuff.

So there were a whole
bunch of factors that were kind of holding the supply side of the economy back,
and those supply-side restrictions collided with a huge burst of demand for
goods and services on the part of consumers. This extremely strong demand was
similarly fueled by several factors: the pandemic was coming to an end, vaccines
were more widely available, people could go back out and lead more normal
lives. Business activity restrictions were lifted or relaxed. This led to a
recovery of consumer demand. The Fed kept interest rates very low, which helped
consumers to spend money. The Fed was attempting to juice the housing sector by
purchasing mortgage-backed securities. That not only led to strong demand for
houses, but it also had spillover effects in other sectors of the economy. And
Congress, through the $900 billion stimulus that was passed in December of 2020
and through the nearly $2 trillion American Rescue Plan that was passed in
March of 2021, also strongly juiced consumer demand. And so you had this big
burst of demand. The supply side of the economy responded but wasn’t able to
respond adequately. And as a consequence, we have had (and are having) consumer
price inflation at the fastest rate in four decades.

I know you’ve done your own calculations looking at
what impact that $2 trillion American Rescue Plan has had on inflation. I think
it was like three percentage points or so. Is that still the case? When you
look at that 8 percent number, people want to know what percent is coming from
supply shocks, what percent is coming from spending. Has that calculation
changed? Are the things causing high inflation right now the same as they were
six months ago?

No, they’re not. Some
of them are similar, but lot of the inflation we’re experiencing now is coming
from higher energy prices due to the war in Ukraine, coming from higher food
prices due to the war in Ukraine. If you look at measures of inflation that try
to remove outliers, or if you look at measures of inflation that try to remove
food prices and energy prices, you see that inflation looks different. Inflation
is still very, very high, but it’s not accelerating. For example, when you look
at the consumer price index but you kick out food and you kick out energy, you
see really fast inflation. You see the price level for those goods and services
increasing much faster than it normally does. But over the past six or seven
months, the problem is not getting worse. It’s not getting better, either.
You’re not seeing the consumer price index minus food minus energy inflation
fall, but you’re not seeing it rise. You are seeing the headline CPI rise.

It seems like whether it’s accelerating or just kind
of staying bad, it keeps being worse than many economists expect. (Maybe not
you, I don’t know.) Why do people keep getting surprised by inflation? Why were
they surprised to begin with? Some economists were saying they didn’t see it,
but now we have it. Do you have a good model, and they have a bad model? Are
there models that aren’t working anymore?

I think it’s a
complicated question. A lot of the models that professional forecasters—at the
Fed, at banks, forecasters in the private sector—a lot of the models that those
professional forecasters use are calibrated or based on the last several
decades of data. And we haven’t had inflation over the last several decades.
And so, if you want to look at the likely effects of the American Rescue Plan—let’s
say you want to say, “Okay, the American Rescue Plan is going to boost GDP by X
amount. That’s going to reduce unemployment by Y amount, and that’s going to
push up prices by Z amount.”

That’s a perfectly
sensible way to try to understand the likely impacts of an economic stimulus
bill. But those Xs, Ys, and Zs are estimated on data from a period where we
didn’t have much inflation. And so if you use those Xs, Ys, and Zs, then by
assumption you are not going to find a big inflation forecast. If you thought, “Boy,
the economy in 2021 is going be a whole lot different than the economy was from
1985 to 2019,” you may not want to use those X, Y, and Z estimates. But then
what else are you going to use, because that’s where the data are? Do you go
back to the 1970s and try to estimate X, Y, and Z from there? Or do you go back
further? So it’s a very hard forecasting problem. But I think the two key
insights are that the American Rescue Plan was really, really big and that the
economy in 2021 was different in some important ways.

Even without the
American Rescue Plan, we were in an environment where the unemployment rate was
falling, where employment was rising, where the economy was growing. Even
without the American Rescue Plan, there were strong tailwinds to demand.
Households were sitting on hundreds of billions of dollars of excess savings as
a consequence of the pandemic. The pandemic was coming to a conclusion, and
that was likely going to lead to a big burst in consumer demand. We were just
on the heels of an economic stimulus bill that was signed into law in December
of 2020 that was larger than the Obama stimulus in 2009. On top of that strong,
underlying demand, we had the Fed engaging in quantitative easing, a zero
interest rate policy, and then a huge additional fiscal stimulus. You know, the
economy is just not going to be able to absorb that without there being a big
increase in prices.

As we’re recording this, about an hour ago the Fed
raised interest rates 75 basis points, the biggest hike since 1994. What does
the Fed need to do to get inflation down back to its 2 percent target? And will
that require or end up causing a recession? And if it ends up being a
recession, is it going to be a modest recession or is it going to be a severe
recession like we saw like in the early ‘90s or early ‘80s?

I think the Fed needs
to reclaim control of the narrative and just kind of generally attempt to take
control of the situation more than it has been. You kind of get the feeling that
the Fed is a participant in this situation, that the Fed is experiencing
inflation along with the rest of us, and the Fed is not out ahead of this. The
Fed needs to get ahead of this. An important part of getting out ahead of this
is kind of reasserting control over the narrative.

Is that because what people believe matters? They have
to believe that the Fed is in control of inflation.

Yeah, that’s right. There’s
a large psychological component to inflation where workers are trying to figure
out, “What are prices going to be in the future?” Businesses are trying to
figure out, “What are prices going to be in the future?” Households are trying
to figure out what a price is going to be in the future. And people’s beliefs
about what prices are going to be like in the future inform their price-setting
behavior today. If you’re a worker and you think we’re in for two, three, four,
five years of high inflation, you want a big raise right now and you want to
condition your employer to expect that you’re going to ask for raises in the future,
right? So they have got to get control of this narrative.

And do they do that with 75 basis points? Do they need
to do that with a number of 75-basis-point hikes? Bigger? Is this a good start?

I think 75 basis
points is a good start. The Fed got it really wrong in 2021, and the Fed was
still purchasing mortgage-backed securities in 2022 at a time when home prices
were growing at 20 percent annual rate month after month.

Did Fed ever get it right?

In the history of the
United States?

Yeah.

Well, sure. The Fed
has engineered soft landings in the past, by which I mean the Fed has slowed
the economy at a time when the economy needed to be slowed without causing a
recession. Certainly Paul Volker inaugurated a 40-year period where we had
relatively low and relatively stable inflation. And other important moments: Chairman
Greenspan, for example, understood that productivity increases in the 1990s
would allow for higher wages without necessarily higher prices. The Fed has
done some very important things.

So the Fed needs to take control of this narrative for
the psychological expectation reasons that you just mentioned. You said it has
engineered these soft landings in the past. Does that feel like what’s
happening now, that we are taking a step toward a soft landing? Is that the
likely scenario?

I think we took a step
toward a soft landing. We are having this conversation, as you said, about an
hour after the Fed’s decision. The 75-basis-point increase was a good step in
the direction of the Fed asserting control over the narrative. I haven’t dived
into the details, yet, of the release. I think the press conference is still
happening right now. But the Fed has had a completely implausible forecast of
the future path of the economy, where they’re predicting price inflation to
come down without unemployment going up.

That sounds like quite a trick.

You could call it an
immaculate disinflation. I think that seems unlikely, and I think it strikes
markets and other important observers as just patently unrealistic. My
understanding is that the forecast that was released today shows unemployment
rising. Having a more realistic outlook for the future is another important
step that Fed can take toward getting control of the narrative. Another
important step is for the Fed to have a more realistic view of the level of
interest rates required to not only slow the economy down, but to stop
providing support to the economy. Right now, the Fed is tightening, but it’s
still providing support to the economy. The Fed has asserted that an interest
rate in the 2.4–2.5 percent range would be . . .

What Interest rate is that?

The federal funds
rate, the Fed’s policy rate. It asserted that an interest rate at that level would
be sufficient to no longer be simulating the economy and supporting demand.
That’s also, I think, quite unrealistic given how high prices are. I think the
Fed boosted that estimate with its release today as well. So these are all important,
right? Communicating to the public that you got it wrong, explaining why you
got it wrong, and making it clear that you’re not going to get it wrong in the
same way in the future is important. Having a realistic view of where the
economy is likely headed (for example, if the unemployment rate is going to go
up) is important. Having a realistic view of what the so-called neutral federal
funds rate is, is important. And I think if the Fed can do that, then that will
give some confidence to investors. It’ll give some confidence to businesses
that the Fed gets what’s happening, the Fed understands the severity of the
situation, and that the Fed is willing to do what it takes to get prices under
control.

There’s this debate, “Are we going to have soft landing,
a hard landing?” How much difference does it make if the recession ends up
being a modest recession? Is that what you would anticipate? Our last big
experience with the recession (setting aside the bizarre shutdown during the
pandemic) obviously is the global financial crisis. Pretty bad. Last year seems
to have broadly played out the way you thought. So over the next year, are you
looking for a severe recession, like we saw during the global financial crisis,
or something more modest that we might even debate if it was a recession like
we saw in 2001 after the dot-com bubble?

So recession: how bad? Would it be like something we’ve
seen recently or a kind of recession we really haven’t seen recently: a mild
one?

I think that remains
to be seen. I think it is unlikely that the Fed will be able to engineer a soft
landing. I think the odds of a recession at some point in the next 18 months
are two-thirds, maybe higher. I think the severity of that recession is TBD. The
arguments in favor of a mild recession are that there is no real underlying
structural problem in the economy right now. We don’t have a situation, for
example, where people own more houses than they should.

Prices have gone up a lot. Isn’t that dangerous?

Prices have gone up, for
sure. Housing prices have gone up. Housing prices are primarily driven by
market fundamentals. Equity prices had also gone up quite a bit. Equity prices
are now down 20 percent, which is probably the more reasonable valuation. Household
debt service ratios are low. Household balance sheets are strong. Businesses
are profitable. So we are in a situation where we can have a kind of textbook
recession: The Fed raises interest rates, that reduces demand, demand goes
down, economic output goes down, we’re in a recession, unemployment rises,
prices moderate.

What you’re describing is not like the global
financial crisis where there were these structural imbalances. And if the
result of that kind of recession is what some call a “jobless recovery,” that’s
not what you would expect this time around. Maybe the unemployment rate goes up
to, I don’t know, 5 percent, but we’re not going to have this kind of grinding
jobless recovery situation afterward.

I think my expectation
would be that employment would recover more slowly than it has from other Fed-induced
recessions in the past. I think that we won’t be in a situation where household
balance sheets are obliterated, where everybody’s net worth has collapsed, where
banks are holding onto assets that nobody knows the value of, where the economy
has to reallocate a large number of housing units, where people have defaulted
on mortgages, and all this sort of stuff—the kinds of systematic economic
problems that take years to unwind. I don’t think we have those right now. And
so I think we would have a recession where demand would drop because of the
Fed. And then when the Fed put its foot on the gas pedal, demand would come
back. And the recession under that scenario would be much more mild.

Does that sound realistic? Does a 5 percent
unemployment rate sound like a bad recession or does that sound reasonable?

I think that would be a relatively mild recession, and I think that’s what we could have. The concern that I have that is growing is that the Fed is so far behind the curve right now and the war in Ukraine doesn’t seem to be ending. My concern is that expectations about future inflation on the part of households and businesses are trending in a bad direction and getting worse relatively quickly. And the Fed can’t end the war in Ukraine, and the Fed can’t do much at all to affect the global price of oil.

But if high oil prices are spooking households and businesses and making households and businesses think that we’re going to have inflation for a long time and are affecting the decisions that businesses are making today about prices as a consequence of those expectations, then the Fed may have to slam on the brakes a lot harder than it otherwise would. And if that’s happening at a time when demand is already cooling as a consequence of high prices, as a consequence of the steps the Fed has already taken, then we still would have a demand-driven recession. It’s not like we’re going to develop a financial crisis in the next few months that will take years to unwind, but the Fed could find itself in a position where in order to get expectations under control it has to increase the unemployment rate significantly higher than it otherwise would.

If we have a recession, unemployment goes up, what
happens to the “Great Resignation”? There have been roughly a million stories
written about the Great Resignation or people not wanting to go back to work. If
we have a recession, they may not have a choice about going back to work. They
may not have to worry about resigning. They may be let go. Speaking of
narratives, does that change the entire narrative of the American labor market
that we’ve been hearing about for the past year?

Well, I think the Great
Resignation is largely a myth. The Great Resignation, I think, is a story like
the one you just told, where workers have decided they don’t want to go back to
work, and businesses can’t find workers as a consequence, and workers have
decided because of the pandemic that the jobs they had before the pandemic are
beneath them in some way or are not good enough for them to do or whatever, and
they’re not coming back. That narrative was fueled by the fact that we’ve had record
numbers of workers quitting their jobs every month. That’s a fact, but that’s
half the story because we’ve also had record numbers of workers getting hired
into new jobs every month. And instead of a Great Resignation, what I see is a
big increase in upward mobility. We’ve had record numbers of workers quitting
and record numbers of workers getting hired. And if you look at wage growth for
workers who change jobs, it’s much higher than wage growth for workers who stay
in jobs. And so people are quitting their jobs, they’re getting new jobs, and
those new jobs pay higher wages. This is a story of upward mobility.

Maybe you’d call it the “Great Climb.”

On a very basic level,
we’ve almost completely recovered all the jobs we lost in the pandemic. If you
look at employment in February of 2020, we’re nearly back to our February of 2020
level of employment. That fact alone, I think, should make you very skeptical
of the Great Resignation story. If we’ve nearly recovered all the jobs that we
lost, then, you know, where are all the resignations?

I think the labor
market will look different. I think we are in a period right now where even
though employment has nearly fully recovered, even though workforce
participation is finally getting close to recovering or closer than it has
been, there is a real change in the labor market in terms of the kind of relative
bargaining power of workers. Workers are in the driver’s seat, right now, in a
way that’s unusual. Why is that? That’s because businesses’ need for workers is
off the charts. The demand for workers is way hotter than we typically see, and
that of course is because consumer demand has been so strong that businesses
need workers in order to satisfy it. I think if we have a recession, and when
we come out the other end, we will see a much more normal level of labor demand.
And that will mean that workers are in a relatively weaker bargaining position than
they currently are in. And so workers demanding huge raises, workers demanding
to be able to work from home, workers demanding to have certain amenities or other
sorts of structures—Fridays off or whatever, all that stuff—I think right now
businesses feel like they have to say yes to all that stuff, because they just
really need workers. And I think it’ll be a little bit more of a buyer’s market
in the labor market when we come out the other end.

One of the most striking
facts about the economy is that if you compare 2021 to 2019, businesses
produced about 2 percent more goods and services; if you compare 2021 to 2019,
they did that with about 2 percent fewer workers. And so productivity has gone
way up. Businesses have figured out how to do more with fewer workers right
now. They still need all the workers they can get their hands on, because
consumers are banging down their doors wanting to buy their goods and services.
When consumer demand cools off, the kind of know-how and business practices
that have fueled that productivity increase aren’t going to go away. They’re
not going to be forgotten. And so we could be in a situation where businesses
regain a lot of the bargaining power they lost over the course of the past year
or so.

So all those unionizing Starbucks baristas better
hurry up.

Yeah. I think it will
be harder to win a union election.

Mike, thanks for coming on the podcast.

Thanks a lot for having me. It’s always great to be on.

The post Are We in the Post-pandemic Economy? My Long-Read Q&A with Michael Strain appeared first on American Enterprise Institute – AEI.