Given the frenzied and contradictory economic news lately, I wouldn’t blame anyone for having a bad case of whiplash. It’s difficult to get a read on what’s happening when the headlines flip between bull and bear faster than the stock market. One moment the discussion is about labor shortages restraining growth even as the administration pitches new relief efforts, how household net worth is skyrocketing even as consumer confidence continues to fall, and how rampant inflation is crushing consumers even though there is almost no new car inventory because makers can’t keep up with consumer demand. Then, seemingly out of the blue, several big investment banks start talking about recessions and, lo and behold, the economy contracts by over 1% in the 1st quarter. This script has more plot turns than an Agatha Christie novel.
Firstly, the negative growth in the 1st quarter was not the story about Q1 GDP, and it certainly wasn’t the start of a recession. The two main aggregates to consider when looking at the economy at the macro level is gross output (GDP) and gross consumption of government, businesses, and households, often referred to by those in the biz as “final demand.” GDP, which shrank in the 1st quarter, is output. But final demand is what’s most important when considering the direction of the economy. Demand drives supply, not the other way around—something that pundits who keep pearl-clutching over supply chain disruptions need to understand. While output shrank by over 1% (annualized), final demand grew by 2.6% in the 1st quarter, a level that is about average over the past few years, and better than the second half of 2021. The additional consumption was not met with more domestic output but by a continuing surge in foreign imports.
Why not more output from inside the United States? For one, the pandemic closed much of the U.S. service sector in the early stages, and this naturally pushed consumption towards goods. Goods, particularly consumer goods, are often produced wholly or partially outside the United States. Hence some of the surge in imports is a natural consequence of the pandemic. But that doesn’t explain the sheer size of the surge in demand. Real, price-adjusted spending on goods today is 16% higher than it was before the pandemic, a level far above recent trends. Moreover, goods spending, and consequently the trade deficit, would surely have been even higher but for supply chain congestion. Take autos, for example, a sector that usually has one million units in inventory waiting to be sold. The March inventory estimate was 77,000 units, a mere fraction of normal levels. And this isn’t unique as inventories are tight in most sectors.
What was truly important in the 1st quarter numbers? Start with the whopping U.S. trade deficit, which reached $300 billion in the 1st quarter alone. This was the largest nominal deficit ever seen in the United States and—at almost 5% of GDP—the second largest ever seen relative to the size of the economy. The largest was in the run up to the Great Recession—a non-coincidence. At that time, the economy was also highly overheated, albeit by Wall Street funny money rather than Washington DC funny money.
With the pandemic now fading further into our rear-view mirror, services are making a comeback although they too are hampered by supply chain issues. These disruptions come in the form of labor shortages. Almost one-quarter of all job openings in the United States are in leisure, hospitality, and other personal services, almost double pre-pandemic norms—leaving restaurants closed when they would like to be open, hotels with rooms left empty, and an hour wait to get a cup of coffee at a casino in Las Vegas! And again, spending would be even higher if Americans could buy everything they wanted and weren’t limited by capacity constraints.
The driver of this extraordinary surge in demand is the excessive stimulus that was injected into the U.S. economy during the pandemic – $6 trillion by Congress and another $5 trillion from the Federal Reserve in the form of quantitative easing. Context is helpful here. A look at national income data suggests the U.S. economy suffered $1.2 to $1.6 trillion in income losses in 2020 and the first half of 2021. The scale of the stimulus compared to the size of the loss and damage to the economy is preposterously large. All that extra cash did exactly what economist Milton Friedman would have predicted in the short run: interest rates fell, asset values surged, and as a result, spending has grown to unsustainably high levels.
This may seem surprising given all the headlines about consumer income not keeping up with inflation. But the spending happening today is not an income-driven or debt-driven surge—it is wealth driven. According to the flow of funds data, net worth in the United States expanded $32 trillion in two years, a 29% increase. And the gains were not just among the top 1% — the bottom 50% of households, by net worth, saw increases of 90%. This hasn’t stabilized consumer demand, but rather supercharged it beyond any reasonably sustainable level. Consumers are driving inflation, and the pain is not evenly shared. For every household that is falling behind, there are multiple households where the primary frustration lies in supply shortages. This is another Friedman prediction: one of the costs of inflation is a high degree of inequality in outcome.
The U.S. economy is clearly overheated. The housing market has experienced a huge jump over the last two years and housing permits have hit decade high levels. Corporate profits are up 20% from two years ago and investment outside of commercial structures has more than recovered. Venture capital investment is up 150% in two years. The stock market is still up 20% from pre-pandemic levels, and job openings remain well above 11 million.
Which brings me to the other important number in the 1st quarter GDP data, the GDP price deflator, a much better estimate of prices and price growth in the economy than the Consumer Price Index as it includes prices from business investment, foreign trade, and government. The GDP deflator was up 6.8% in the 1st quarter, compared to 2% annual average increases over the previous decade. That is the highest number in almost half a century and it should be ringing alarm bells across the Federal Reserve.
Instead, we’re hearing only excuses for inflation (supply chains, green energy policies, the Ukrainian conflict, China’s COVID lockdowns, etc). All this simply confuses proximate causes of price inflation with the overarching cause—the massive increase in the money supply created by the Federal Reserve’s $5 trillion in quantitative easing. Without the demand, there is little doubt that this money would eventually have found its way into prices—just at a slower rate. Equivalently, the $6 trillion in Congressional stimulus would have caused some inflation even if the Fed had enacted no quantitative easing. But put together, they created an inflation firestorm, one that is zero percent contained.
From the beginning, what’s been most astonishing about the actions of the Federal Reserve is how unnecessary they were. Yes, there was a financial panic at the start of the pandemic, and it was reasonable for the Fed to try and give the markets confidence. But they quickly decided on $3 trillion in quantitative easing despite there being no evidence that the financial markets would undergo the same kind of meltdown they did when the subprime mortgage bubble popped. By the 3rd quarter of 2020, as it became abundantly obvious that the pandemic was not going to cause a depression or even a serious recession, the Fed should have hastily removed the cash from the system. Instead, they added $2 trillion more in quantitative easing over the next two years—a decision that will assuredly go down in history as one of the worst ever made by the Federal Reserve board.
Now, the ratio of money to the nominal size of the economy is 25% above normal and, according to basic monetary economics, that means 25% more inflation over the next few years to get everything back into alignment. A more sophisticated look, which controls for the impact of inflation on velocity, suggests an even higher number.
There is little doubt that both the Fed and the White House are worried about the political fallout from inflation—and both have announced intentions to reduce the pace of price growth. Which brings us to the recent announcement from the Fed regarding future policy. The center of that announcement were the hikes in the Federal Funds rate. But that is a largely useless move because today’s economy is being driven by cash, not debt. Long run rates are already up and the Fed is simply pushing the short end of the curve up after them.
The only way to cure current inflation is for the Fed to pull out the cash they put in—something on the order of $4 trillion in quantitative tightening. The baby steps they announced suggest it will take four years before $4 trillion is fully withdrawn, and this will be after prices have already surged another 20%. The Fed must do far more, and quickly, before inflation becomes an even more endemic problem than it was in the 1970s. Yet, they seem to be more concerned about potential implications for workers despite record earnings growth, job openings, and quits.
The U.S. economy is overheating, over-spending, and over-inflating. It’s like careening down a hill in a car at 120 MPH, headed straight for a parked truck, but worrying about tapping the brakes too hard because you don’t want the car to slide. We might as well forget that soft landing.
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