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Recession looks more likely but less bad

by Thomas L. Hogan, opinion contributor - 01/19/23 1:00 PM ET

AP Photo/Jacquelyn Martin
Federal Reserve Chair Jerome Powell speaks at a news conference Wednesday, Sept. 21, 2022, at the Federal Reserve Board Building, in Washington. Intensifying its fight against chronically high inflation, the Federal Reserve raised its key interest rate by a substantial three-quarters of a point for a third straight time, an aggressive pace that is heightening the risk of an eventual recession.

A recent survey found 70 percent of economists expect a recession in the coming year, up from 49 percent in July, and 63 percent in October. Two thirds of major financial institutions agree. Even the Federal Open Market Committee (FOMC) has a median projection of GDP growth of just 0.5 percent in 2023, which could mean a recession early in the year.

As dire as these predictions sound, the current outlook is less bad than a few months ago. Though no one wants a slowdown in the economy, nor an increase in unemployment, there are reasons to think the outlook is more optimistic — or at least less pessimistic — than some economists are letting on.

Low chance of stagflation

Recent data indicate that we have likely avoided the worst-case scenario: stagflation. If inflation were to remain high and the economy does go into recession, the Fed would have the unenviable choice either to raise interest rates to address inflation or lower rates to expand the economy, but it cannot address both problems at once.

A few months ago, stagflation appeared a real possibility, especially if the public began to expect inflation would remain high for years to come. High inflation expectations cause workers to demand higher wages, which may result in higher unemployment, as occurred in the stagflation of the 1970s.

Luckily, inflation expectations have recently started to fall. Three key measures of expected inflation have all declined over the past six months: The University of Michigan Survey of Consumers, the spread between U.S. Treasury bonds and Treasury Inflation Protected Securities (TIPS), and the Federal Reserve Bank of Cleveland’s estimate of financial markets’ expected inflation. Stagflation now appears unlikely.

Flexibility for the Fed

Most of the inflation over the past two years has been caused by the Fed’s overly expansionary monetary policy. The FOMC was too slow to respond to high inflation, but it has finally raised its interest rates targets to a point that they believe will help bring inflation down.

If high inflation persists, the Fed may choose to continue raising interest rates, which could have the unfortunate effect of tipping the economy into recession. In such a case, the Fed would be limited in its ability to stimulate growth by cutting interest rates, for fear of inadvertently reviving inflation.

The most recent data appear to show inflation to be either stable or falling. In 2022, inflation, using the Fed’s preferred measure of core Personal Consumption Expenditures (PCE), fluctuated around 5 percent. Looking at individual months rather than the past 12, the annualized rate of inflation was just 3.1 percent in October and 2.0 percent in November.

If the downward trend continues and inflation stabilizes or declines, the Fed may have room to lower rates in response to any economic downturn.

Downturn may be small

If a downturn does occur, the damage is likely to be less severe than many economists were previously predicting.

A survey of economists by the Wall Street Journal found that while most are predicting a recession, they only expect the unemployment rate to rise to about 5.0 percent, up from 3.7 percent in November. The median FOMC member is projecting an unemployment rate of 4.6 percent by the end of 2023. Both estimates are below the U.S. long-run average of about 6.0 percent, so these downturns would be moderate compared to most U.S. recessions.

Of course, we don’t want anyone to lose their jobs. Ideally, everyone would remain employed, or at least jobs lost in one sector of the economy were made up for by gains in another. But even if unemployment does reach 5 percent, that would be much less damage than the economic disaster some had predicted.

The economic outlook is much better than it was just a few months ago. A recession still appears likely, but the scale of the damage — in terms of unemployment, inflation, and economic growth — may be less bad than previously thought.

Thomas L. Hogan is a senior research faculty member at the American Institute for Economic Research. He was formerly the chief economist for the U.S. Senate Committee on Banking, Housing, and Urban Affairs.