By James Pethokoukis and Michael Strain

For the past two
years, the COVID-19 pandemic has dominated discussions of the US economy. But
now, with inflation and the possibility of a recession on everyone’s
minds, are we in the post-pandemic economy? To get a sense of the current
economic moment, as well as what’s next for the US economy, I’m joined by
Michael Strain, whose macroeconomic forecasting during the pandemic has been on
point.

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).

Below is an abbreviated transcript of our conversation. You can read our full discussion here. You can also subscribe to my podcast on Apple Podcasts or Stitcher, or download the podcast on Ricochet.

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

Strain: 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. It was due in part to
pandemic-era programs that expanded the generosity of unemployment benefits or
that just expanded household savings generally.

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.

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 a 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.

Are we heading into a recession?

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.

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 would the recovery from such a recession look like?

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 with the kinds
of systematic economic problems that take years to unwind. 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.

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. If high oil prices are spooking households
and businesses into thinking 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.

If we have a recession, what happens to the “Great Resignation”
narrative?

I think the Great Resignation
is largely a myth. Instead of a Great Resignation, what I see is a big increase
in upward mobility. 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.

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. I think if we have a recession, and when we come
out the other end, we will see workers in a relatively weaker bargaining
position than they currently are in.

The post 5 Questions for Michael Strain on Inflation, Recession, and the Labor Market appeared first on American Enterprise Institute – AEI.