Against panic: The Fed should not be given permission to cause a recession in the name of inflation control

The disappointing May data on consumer prices—showing continued strong growth of overall inflation and no real reduction of core inflation—seem to have been a turning point in how many influential policymakers and analysts view the U.S. inflation problem. In particular, it has inspired near-panic and damaging exhortations that the Federal Reserve should push the economy to the brink of recession in the name of fighting inflation. It has also led to preemptive absolutions of the Fed of any criticism that might come their way if a recession does result from steep interest rate increases.

This panic is unwarranted, and the Federal Reserve should not feel free to ratchet up interest rates without regard to the risk of recession. Years from now, a recession induced by the Fed raising rates too quickly will be seen clearly as a policy mistake that could have been avoided. This conclusion stems from several simple facts:

  • Both real output and the economy’s underlying productive capacity (potential output) are essentially in line with what pre-pandemic forecasts projected by mid-2022. None of these pre-pandemic forecasts indicated this would imply economic overheating by now. Given this, the macroeconomic balance between demand and supply cannot be so out of alignment that it explains a large share of the acceleration of inflation in the past 15 months.
    • Crucially, potential gross domestic product (GDP) was clearly above actual GDP for most of 2021 when inflation started. This is very hard to square with macroeconomic imbalances driving the rise of inflation.
    • Finally, there is rich, existing literature on the degree of inflation to expect given an overshoot of aggregate demand over potential supply. These estimates imply substantially less inflation than we’ve seen to date, meaning that factors besides simple macroeconomic imbalances are likely at play.
  • While the May price data were discouraging, there is reason to think that some of the drivers of inflation in recent months may be losing steam.
    • Profit margins are still at historically high levels but have come down significantly in 2022.
    • Wage growth has lagged inflation over the entire episode and has even decelerated in recent periods. This means that wages’ role as a dampener of inflation looks set to continue (and maybe even strengthen) in coming months.
  • The main channel through which higher interest rates will put downward pressure on prices runs through a softer labor market (higher unemployment) reducing growth in labor incomes, which reduces demand and reduces pressure on prices from the cost side as well. But, labor income growth has not been a key driver of inflation so far; in fact, wage growth has significantly dampened the growth of inflation over the past 15 months. In the past six months, hourly wage growth is actually running at a pace entirely consistent with the Federal Reserve’s 2% long-run inflation target.

It has become fashionable to confidently assert that the Fed was “caught flat-footed” by the rise in inflation. This assertion combines bad judgement on two fronts. First, it’s a far too-confident political judgement that inflation clearly reflects worse on policymakers’ judgement than a recession would. Second, it’s a clearly flawed economic judgement about the sources of the inflationary surge in 2021 and 2022, as well as what is necessary to return inflation to normal levels. Put simply, the primary inflation-relevant variable that the Fed’s policy actions can affect—labor income growth—has been dampening inflation over this entire period. Given this, it is far from clear that the Fed should have acted much more aggressively or that the Fed’s seeming turn to a more-aggressive policy going forward is welcome.

However, the Fed is absolutely setting themselves up to get caught flat-footed in the near future if a steady diet of interest rate increases throws the economy into recession. The recently oft-repeated formulation that the Fed must do “whatever it takes” to push down inflation is downright reckless. Monetary policy operates with a lag. By the time it’s clear in the data that the labor market has been deeply damaged by interest rate increases, it will be too late to avoid a recession.

The fact of faster inflation is not proof of large macroeconomic imbalances

There is a growing willingness to point to the simple fact of fast inflation as evidence that it has been caused by a large macroeconomic imbalance of aggregate demand running far ahead of the economy’s productive capacity, and that only contractionary policy can remedy this imbalance. This is flawed economic reasoning, for a couple of reasons.

For one, the level of output currently being produced in the United States, and the underlying productive capacity of the economy, are essentially in line with projections made for early 2022 by forecasters before the pandemic. These forecasts had no sign of inflation in them. If we’re in line with those, then, it is quite unclear why the current level of output could not be produced without lots of inflation.

For another, past episodes of the economy “heating up” as unemployment falls and inflation accelerates have been universally accompanied by real (inflation-adjusted) wage growth and a rising labor share of income. The past 15 months have seen the opposite: falling real wages and a rising profit share.

Figure A below shows both real gross domestic product (GDP) and potential GDP (what the economy could produce if unemployment was roughly 4%). Each line is the ratio of the current estimate relative to pre-pandemic forecasts. For a current estimate of potential GDP, I adjust for the lower labor force participation rate and the (slight) shortfall in business investment that has occurred since the pandemic began. It is perhaps underappreciated how little gap remains now between pre-pandemic forecasts of potential GDP and reasonable estimates of its current value—the labor force participation rate is near-totally recovered and investment has been growing tolerably well since the pandemic recession in 2020.

Figure A

Relative to pre-pandemic forecasts, the U.S. economy should be able to produce today’s level of output with very little inflation: Ratio of forecasted real GDP to actual GDP and forecasted potential GDP to estimated potential GDP

Real GDP Potential output
2019Q3 100.0% 100.0%
2019Q4 99.9% 100.0%
2020Q1 98.1% 99.9%
2020Q2 88.8% 97.3%
2020Q3 95.0% 98.0%
2020Q4 95.5% 97.9%
2021Q1 96.5% 97.8%
2021Q2 97.7% 98.0%
2021Q3 97.9% 98.1%
2021Q4 99.1% 98.3%
2022Q1 98.3% 98.9%
2022Q2 98.4% 99.3%
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Notes: Forecasts are from Congressional Budget Office (CBO) January 2020 Budget and Economic Outlook. To account for potential declines in potential GDP, I reduced this measure by 0.7 times the ratio of actual labor force participation (LFP) to the LFP projected by CBO. This reduces potential output substantially in the early parts of the pandemic recession, but this measure has largely recovered. I also reduce potential GDP by 0.3 times the ratio of trend growth in capital service inputs to actual growth in these inputs. The trend is based the 2000–2019 period, and both this trend and the data over the past six quarters is taken from the Fernald series on productivity growth. I don’t account for changes in total factor productivity (TFP) growth, but this would actually boost potential output relative to forecast over the past six quarters.

Source: EPI analysis of data from Congressional Budget Office (CBO) January 2020 Budget and Economic Outlook and 2009–2019 data from the Fernald series on productivity growth.

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Crucially, in the months when inflation began rising rapidly (mid-to-late 2021), actual GDP remained below potential GDP by these measures. It was only in the last quarter of 2021 when GDP mildly overshot potential GDP (by roughly 0.8%).

This overshoot is nowhere near large enough to have driven the rapid rise in inflation. There is a rich pre-pandemic literature relating inflation and positive output gaps (i.e., inflation arising due to GDP overshooting potential). Even the largest of these estimates (which allow for highly non-linear relationships between output gaps and inflation, with inflation rising more rapidly the more GDP overshoots potential) indicates that a 1% positive output gap should raise inflation by roughly 0.3%. These estimates would require positive output gaps (GDP overshooting potential) of about 10-15% to generate the increase in inflation we’ve seen over the past year if this macroeconomic imbalance was the only cause. This doesn’t seem credible.

This kind of gap analysis is admittedly far from dispositive. But it’s important to walk through for one important reason: Many of those arguing for the most aggressively contractionary stances from the Fed are claiming authority from having been vindicated in their claims that the fiscal relief packages passed in 2021 might spur inflation. But, the predictions that these relief packages would spur inflation were based exactly on this type of gap analysis reasoning. The only difference is that the predictions in early 2021 were explicit that real GDP would be pushed far above potential GDP for an extended period of time, and that is why inflation would result. This overshoot has not happened. There is no serious vindication of their analytical predictions here and hence their arguments should get no special privilege going forward.

Shocks, ripple effects, and components of price growth

Pitted against the view that recent inflation is caused solely by a macroeconomic imbalance is a view that instead sees inflation caused by a series of large shocks (pandemic and war), which set off ripple effects as various economic actors tried to pass on the inflationary shock to others. For example, as pandemic distortions pushed up durable goods prices, workers targeted higher nominal wages while firms looked to protect (or even fatten) profit margins. The shocks have been more frequent and longer lasting than many might have imagined back in March 2021, and the ripple effects larger.

But, based on this view, there is no evidence that the ripple effects are amplifying the initial (and inevitable) inflationary shocks. After a year of pushing up prices significantly, profit margins have started to thin in recent quarters (they’re still fat in historical perspective, but clearly coming down, as shown below in Figure B). Wages have been dampening the initial shocks throughout the past 15 months and show signs of decelerating further. If growth slows throughout the rest of 2022, as is generally projected, it is hard to see the ripple effects of the past year’s shocks doing anything but fading out.

Figure B

The profit margin spike of 2021 is relenting, but margins are still historically high: Pre- and post-tax profit margins, recently and historic averages

Pre-tax Post-tax
2016Q1 16.0% 12.7%
2016Q2 14.7% 11.3%
2016Q3 14.6% 11.4%
2016Q4 14.0% 11.0%
2017Q1 14.5% 11.9%
2017Q2 14.6% 12.0%
2017Q3 14.1% 11.4%
2017Q4 14.2% 11.6%
2018Q1 14.5% 12.4%
2018Q2 14.8% 12.4%
2018Q3 15.3% 13.0%
2018Q4 15.8% 13.4%
2019Q1 14.1% 12.0%
2019Q2 14.6% 12.3%
2019Q3 14.6% 12.6%
2019Q4 14.9% 12.6%
2020Q1 13.2% 11.5%
2020Q2 13.1% 11.1%
2020Q3 17.7% 15.2%
2020Q4 15.8% 13.4%
2021Q1 16.9% 14.3%
2021Q2 19.0% 16.1%
2021Q3 18.5% 15.8%
2021Q4 17.8% 15.1%
2022Q1 17.0% 13.9%


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Note: Profit margin calculated as unit profits divided by the sum of unit labor and non-labor costs. 

Source: EPI analysis of Bureau of Economic Analysis (BEA) National Income and Product Account (NIPA) Table 1.15.

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It is worth ending with more discussion about wages. The one point of seeming agreement between those arguing for an aggressive reaction by the Fed to brake growth and those arguing against this aggressive reaction is that the key variable to monitor going forward is wage growth. The way the Fed’s interest rate increases would eventually slow inflation largely runs through their effect in raising unemployment and sapping workers’ bargaining power which restrains wage growth. Since wages are both a key source of demand and a cost for firms, this will put downward pressure on inflation.

But in the most recent quarter (March–May), wages grew by just 4.3% (at an annualized rate) compared with the previous quarter (December–February). In the last two months, monthly wage growth (expressed at an annualized rate) has averaged 3.8%. These are wage growth numbers fully consistent with the Fed’s long-run inflation target of 2%. (For more on why a 2% inflation target is consistent with 3.5-4.5% wage growth, see the discussion around Figure C here.)

Using aggressive contractionary monetary policy to squash wage growth even more will put a huge burden on workers to restrain inflation—when they have been the primary victims of it so far. Further, this strategy will leave all the other determinants of inflation—which actually are contributing to its above-normal level—largely untouched, until at least a pronounced slowdown or recession results.

The current panicked demands that the Fed raise rates until something breaks is terrible advice based on bad economic and political analysis. The Fed should instead lay out some real guideposts for how they think their rate increases will slow economic activity and what would constitute an excessively fast deceleration of growth. They should have a plan to pivot and stop rate hikes if there’s evidence they’ve gone too far—that is, if they might cause a recession. They should begin publicly highlighting high-frequency data on wages to assess just how much more labor market softness really would be needed to normalize inflation through labor market channels. In short, they should know that unless wage growth really does become a key amplifier of inflation, then a Fed-induced recession will be seen as a clear policy error and there should be no preemptive permission to make this mistake.