There’s a lot of uncertainty and confusion around what’s happening in our economy these days. So it’s no surprise that it’s a hot topic for questions I get from students and business colleagues near constantly. So let’s tackle it in this week’s Ask Harry blog post:
Ask Harry #4
“How do I make sense of what is happening in the economy?”
If you look at the headlines from day to day, I can appreciate why it appears very confusing. One day it looks like the Fed will increase rates aggressively, the next day it looks like they will increase rates very slowly, or stop interest rate increases completely. Some economists believe interest rates are already too high, and others say they are not high enough. When employment figures show a strong increase in employment, rather than that being a positive sign for the economy, it is interpreted as a negative. So what’s going on, and how to predict what comes next?
As I always tell my students, let’s try to keep the discussion “simple” and start at the beginning. I believe that what makes economics fascinating is that it is less about numbers and more about expectations. The US Federal Reserve has a long-standing policy of targeting the inflation rate at 2%. For many years, despite large deficits, many economists were surprised that inflation stayed very close to the target rate. My personal opinion is that the stable, low rate of inflation occurred simply because the EXPECTATION of most people was that the inflation rate would not rise. Said another way, if the expectation is that inflation won’t increase, people won’t ask for significantly higher wage increases, and companies will not increase prices significantly to cover the cost of providing the higher wages, which causes still higher expectations of wage increases, and so the cycle continues.
So what happened to cause a significant increase in inflationary expectations? My opinion (remember I have very few answers) is that we got a “perfect storm:” the combination of COVID lockdowns, significant global supply change disruptions, the “great resignation” that limited the size of the workforce, and the war in Ukraine putting significant pressure on energy prices. The result was people, for the first time in many years, significantly increased their inflation rate expectations, and started demanding higher wages, which spiraled its way through the system to where we are today.
So what has the Fed been trying to do? In summary, they are attempting to reduce inflationary expectations by increasing interest rates with the goal of slowing the economy without causing a significant recession. Many people are criticizing the way the Fed is working, but I wonder if they realize the delicate BALANCE involved. Here’s the tradeoff between the two views:
- Perspective #1: Interest rates are already too high and have increased too fast, and we should stop further increases now. These economists believe there is a lag between the interest rate increases and the impact on the economy and changes in inflationary expectations. They argue that interest rates are already high enough to slow the economy, and we are in danger of causing a significant recession if rates go much higher. They argue that the economy is already slowing down in many areas.
- Perspective #2: These economists believe that inflationary expectations are still too high and unless the economy really slows down, inflation will continue to do significant harm to the economy, especially to lower income people. They see the continuing increase in employment data as a sign that the economy is not slowing down, and inflationary expectations will continue to significantly exceed the 2% target.
So what is the right thing to do?
Clearly, there is some truth to both perspectives. For example, the recent total collapse of Silicon Valley Bank (SVB) is a clear indication of what can happen when interest rates increase too quickly (i.e., supporting perspective #1). In this case, SVB took billions of dollars in deposits and invested them in fixed rate instruments because those instruments were generating a higher return compared to other options at the time. However, with further increases in interest rates, combined with their client companies and individuals liquidating deposits to fuel their cash needs, caused SVB to sell significant assets at a high loss to cover the withdrawals. This created a negative equity balance, placing the bank in a precarious financial position, triggering, in essence, a “bank run,” and ultimately leading to the bank’s insolvency. This article in the Wall Street Journal does a great job laying out the specifics that led to SVB’s implosion, which, by the way, is the second-largest bank failure in US history.
Regarding perspective #2, let’s not forget that inflation has a tangible impact on people’s lives. When increasing inflation causes a typical food basket of $100 to become $112, this may not be a significant impact on middle or higher-income people, but it can be devasting for lower-income folks. If not kept in check, runaway inflation can have a dramatic impact on a country.
Well, I once again repeat one of my favorite quotes from the famous New York Yankees baseball player Yogi Berra, “It is difficult to make predictions, especially about the future.” My sense is that this really is a delicate balance. Since I am old enough to remember the early 1980s and what Fed Chairman Paul Volcker had to do to wring inflation out of the market, I definitely favor the second approach. Yes, I realize this can cause a larger recession with some significant impact to financial institutions like SVB in the short term, and as happened in the aftermath of SVB’s failure, may require further government intervention to manage the fallout. Unfortunately, this may be the price we have to pay to get the economy back on track.
Illustration by Mike Werner