And now for something completely different. Instead of the usual newsletter format, today’s edition will be a dialogue with my colleague Peter Coy over near-term economic prospects. Peter and I have been engaged in a sort of implicit dialogue for months, in the sense that our respective newsletters have been offering dueling takes on the economic situation. But over the past week Peter and I engaged directly, and we thought it might be interesting for others to read our exchanges.
So here’s the question: Are we getting closer to a soft landing, a recession, or something different?
Peter Coy: Before I answer your question, let me say that there’s a big difference between predicting and wanting. I do not want a recession. That said, I do think that there’s probably going to be one, either this year or next. I’ve written pessimistic takes in my Times newsletter, including a piece in July titled, “Sorry, but I Still Think a Recession Is Coming.”
I hasten to acknowledge that I’m not an economist, nor do I play one on TV. Paul, you are an outright Nobel laureate; I’ve never even been to Stockholm. But as I argued in my July newsletter, I’m not asking you to take my word on this. I’m just doing my journalist thing of pointing out facts. And one big fact is that the Federal Reserve has never raised interest rates this much, this fast without causing a recession.
The bottom end of the target range of the federal funds rate has gone up to 5.25 percent from zero in March of last year. We still haven’t felt the full effect of that enormous increase. As economists like to say, monetary policy has “long and variable” lags. The average length of time between the start of a Fed tightening cycle and the start of a recession is around 22 months. That would put the start of a recession around January — although as I said, the lags are variable.
Paul Krugman: I agree that there’s a big difference between predicting a recession and wanting one. There’s also a related difference between believing that we need a recession — even if we don’t want it — and believing that we’ll have one.
At the beginning of this year many economists — most famously Larry Summers, but he had plenty of company — believed that we needed a recession to get inflation down, as we did after the inflation of the 1970s. As of last December, the Fed’s economic projections said that inflation would come down, but only at the cost of a sustained rise in unemployment to more than 4.5 percent.
At this point, however, the case for believing that we need a recession to curb inflation is very close to unsustainable. As I wrote last week, what we’ve actually seen is rapidly declining inflation with no significant rise in unemployment; it looks as if inflation was transitory after all.
The question now is whether we’ll get a recession anyway — basically, whether Fed tightening will produce an unnecessary recession. And the picture there is very muddy. Milton Friedman’s famous line about “long and variable lags” has come in for a lot of questioning lately, with some suggestions that the lags may have gotten a lot shorter. If the lags are long, we may stumble into a recession; if not, not.
Honestly, I don’t know what I believe here. This whole pandemic-driven cycle has, to use the technical term, been weird. Historical analogies don’t seem nearly as useful as they usually are. The economy has been amazingly resilient so far in the face of rate hikes, but I have no idea whether that will continue.
Put it this way: If our story is that Fed tightening will produce a recession, we’d expect that to work mainly though housing, the usual channel. Indeed, Fed hikes led to a big rise in mortgage interest rates, which hit 7 percent almost a year ago and have fluctuated since then. But housing starts, after an initial drop, have ?g=18YuJ” rel=”noopener noreferrer” target=”_blank”>stayed fairly strong — at or above prepandemic levels. So the usual process by which hikes produce a recession doesn’t seem to be operating. There may be other ways a recession can happen, but as I said, the historical correlations may not be much of a guide.
Coy: Paul, you were right to call out those who thought we needed a punishing recession to get inflation down. I also agree that the economy is weird lately. The labor market has held up surprisingly well, which is wonderful. Housing is pretty good, too.
But cracks are forming. A lot of signs that a recession could be coming. To start with housing, since you brought it up, high mortgage rates are freezing sales of existing homes. People don’t want to move because they’ll have to replace their cheap mortgage with a more expensive one. So the market is thin — not many homes for sale, and shoppers can’t find what they want. Also, basically no one these days can refinance and get a better rate, so that’s a potential source of cash for consumers that’s absent. The Mortgage Bankers Association said Sept. 20 that its index of mortgage applications, which includes refis, rose in the preceding week, but it was still back where it was in 1997. I can hardly remember 1997.
The labor market isn’t as resilient as it appears at first sight, either. A lot of the jobs that are being created are part-time. Average weekly hours worked in the private sector fell slightly in the 12 months through August. If you look at aggregate hours worked by everyone, they rose only 1.8 percent over that period. If the Fed is waiting for the labor market to break before it eases up, it’s going to end up waiting too long, because by then it will be too late.
I’m also still worried about how the banks are dealing with rising interest rates. There were some big failures early this year. When rates go up a lot, banks have to start paying more for deposits or borrowing. But what they earn on their loans and the bonds they own doesn’t go up as quickly. That squeeze has not gone away. Now layer on work-from-home, which is killing commercial real estate. According to the Fed’s survey of senior loan officers, banks are tightening their lending standards for commercial and industrial loans by the most outside of the past three recessions.
Krugman: I don’t really disagree with concerns that cracks may be forming. One way to say this is that the same thing that raises doubts about tight money causing a recession — interest rates have been high for a long time, and no recession yet — also means that we may be seeing stresses build up over time.
On the other hand, you could point to things like the expansionary effects of Biden’s industrial policies, which seem set to spend a lot more than initially expected (because so many companies are investing in green energy).
The thing is, economists have a perfect track record when it comes to forecasting recessions. They’ve never been right — not because they’re stupid, but because it’s really hard. In fact, it’s hard even to know what’s happening now — various G.D.P. “trackers” are showing everything from torrid growth to decline.
That’s why I’m a lot more comfortable with an analysis of whether we need a recession (no) than with the question of whether we’ll have one anyway. Unfortunately policymakers can’t put the world on hold while they do more research. I guess at this point I’m worried that the Fed may have overshot, especially with a government shutdown looking very likely. (In fact, I’m having a hard time figuring out how we ever get spending legislation, given the craziness within the G.O.P.).
Coy: I agree that Biden’s industrial policy is helping growth, but other fiscal factors are sapping it. We have the expiration of the expanded child tax credit and the end of the suspension of student loan payments, for two. These are weighing on an economy that’s already fragile. If there is a recession, a lot of people who didn’t see it coming will attribute it to the government shutdown, assuming there is one, or the autoworkers’ strike, or sunspots. I don’t know. But there will always be special factors, positive and negative. The big act, to repeat, is the sharp rise in interest rates.
Since we have the floor here, I’ll bring up an oddity about interest rates and inflation. Most economists, including I guess almost all of those at the Federal Reserve, will say unreservedly that higher interest rates reduce inflation by cooling economic activity. But as I wrote in a newsletter last year, the public doesn’t necessarily see it that way. Researchers found that 57 percent of respondents thought that a rise in the federal funds rate would lead to a rise in inflation. Just 30 percent thought it would cause inflation to fall. That kind of makes sense. When interest payments go up, it feels like inflation.
So here we have Jay Powell determined to anchor expectations for inflation at the Fed’s 2 percent target, but the more he raises rates, the more he makes a lot of people feel like inflation is going up. It’s like the old joke: The beatings will continue until morale improves. Curious what you think about that, Paul.
Krugman: Again, the big rise in the interest rates that matter for the economy mostly took place in the first nine or so months of 2022, because markets were anticipating further Fed hikes. How much of the downdraft from those hikes has yet to be felt? I really don’t know, but many observers think most of the hit has already happened. I’d say time will tell, but as you say, if we do have a downturn people will cite many factors, and the debate will probably go on.
On interest rates and expectations: When we talk about expected inflation, I always ask whose expectations. Bond market traders listen to Fed news conferences, but they don’t set prices of goods and services. Neither do consumers. We don’t have as many sources on business expectations, but for what it’s worth they seem to have come down.
But I think we’re getting close to the point where the Fed stops being very concerned about inflation. Right now it looks as if we’ll be getting close to the 2 percent target within a few months. And if the economy does seem to be hitting a pothole, we could see policy reversing.
I’d add that I don’t expect the public to admit that inflation has come down for quite a while. My experience is that if you point to the numbers, you get a lot of hate mail — even though when you ask people how much inflation they expect in the future, that number has come down a lot too. I guess my point is that I don’t think we should take what people say about interest rates and inflation all that seriously.
Coy: You know what makes me really nervous about a recession? When the Fed stops being nervous about a recession. Because then the Fed is more likely to raise interest rates when it shouldn’t, or fail to cut interest rates when it should. And that makes a recession all the more likely.
Based on last week’s policy statement and economic projections, the Federal Open Market Committee sees very little chance of a downturn. The median growth forecast for this year went up to 2.1 percent, from the forecast of 1.0 percent in June. The forecast for next year went up to 1.5 percent, from 1.1 percent in June. Clear sailing!
If the F.O.M.C. had a really excellent track record in forecasting, its optimism might be encouraging. But the F.O.M.C. has repeatedly failed to spot turning points in the economy, whether up ones or down ones. I’m afraid it’s happening again.
Krugman: The Fed’s optimism makes me nervous, too — shades of the days when Ben Bernanke declared that the subprime crisis had been “contained.” But while the Fed (and everyone else) is very bad at calling turning points, I don’t think it’s a reliable negative indicator either — that you can safely predict a recession because the Fed doesn’t expect one.
What was really striking about the Fed’s latest projections is the growing optimism about the possibility of a soft landing. If you go back to the projections from last December, the Fed’s expectations about future inflation haven’t changed much. But back then it was expecting disinflation via a sharp rise in unemployment, which is now gone from the projections.
One other piece of data: The latest numbers on new claims for unemployment insurance, which sometimes acts as an early warning signal for slumps, are, according to people who know this stuff, “phenomenal” — at their lowest point since January. So no sign that a slump is happening yet.
Coy: We could end up having a Twilight Zone recession where the unemployment rate never really goes up very much. I actually wrote about that possibility last month. That would be a good outcome — economic output falls but employers don’t shed a lot of people, possibly because they know how hard it will be to staff back up when the recession is over. We worry about A.I. putting us all out of work, but for now the problem is a chronic, underlying lack of workers, not a surplus. But I guess that’s a topic for another time.
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