Much has been made about an imminent, full-blown recession, triggered by the unwinding of record stimulus by the Federal Reserve and resulting steep correction in stock and bond prices.
While the clearing out of speculative froth from the markets may be wrenching, there is little evidence in the investment and consumption fundamentals of the business-cycle recovery to support a dire outlook. In fact, most economists you hear from are misreading and misinterpreting information about how we got here.
I will show, below, that the massive rise in unemployment and deep contraction of the economy two years ago were little more than a blip — nothing like the tumultuous 2008-2009 crisis. And that the inflation spike will soon fade as resources are reallocated to more critical infrastructure and productive uses, and prices in the economy find an equilibrium that’s been the norm for decades.
The start of the pandemic
When the Covid-19 pandemic shock occurred in February 2020, there were no structural imbalances in the economy.
There was no evidence of excess risk taking by a well-capitalized banking system, by businesses or by individuals.
But the pandemic necessitated a widespread shutdown of the economy in March and April, and the unemployment rate spiked from 3.5% in February 2020 to 14.7% in April.
There were frenzied pronouncements of a Great Worldwide Pandemic Recession. Many reputable analysts went brain dead and jumped on the doomsday bandwagon. But the second-largest economy, China, did not experience a recession, but rebounded sharply after a brief shutdown to report yearly growth of 6.5% at the close of 2020.
A misreading of the unemployment situation
But even more astounding than the poorly informed, and premature, prognosis on China, was the gross misread of employment in the U.S.
Tracking the state of the employment markets during the pandemic upheaval proved to be a daunting task. But looking at the big picture, according to the Bureau of Labor Statistics, 99.4% of the increase in unemployment from February to April 2020 — a total of 17.3 million — was accounted for by temporary layoffs, most of them legally mandated restrictions and closures.
Moreover, 85% of the temporary layoffs were reversed by October 2020, and the increase in permanent layoffs from February 2020 to November 2020 was only 2.7 million, or 1.7% of the labor force.
Contrast that reality with the 2008-2009 recession, when the increase in unemployment from March 2007 to October 2009 was 8.6 million, with less than 1 million due to temporary layoffs.
In sum, the underlying unemployment rate rose by only 1.5 percentage points, to near 5%, during the initial wave of the pandemic[BB1] .
Applying Okun’s law — which shows the relationship between unemployment and gross domestic product — the “endogenous” decline in underlying real GDP was only 3 percentage points. The remaining 7 percentage points of the 10.1 percentage points in early 2020 was due to temporary, legally mandated shutdowns and associated temporary layoffs.
The National Bureau of Economic Research (NBER), the research organization that dates recessions, was quick to pull the trigger, announcing on June 8, 2020, that a recession commenced in March. A year later, on July 19, 2021, the NBER said the recession ended in April 2020, the shortest two-month “recession” in the history of the country.
The powerful and unprecedented recovery of employment and output since May 2020, the swift recalls of temporary layoffs, even in the face of subsequent pandemic waves, now leads to the question: Was there a “bona fide” recession in 2020?
The fiscal-monetary counterpunch
The egregious misread of the employment market, combined with negative bandwagon effects, led to the massive fiscal-monetary stimulus that was unleashed from March to May 2020. The scope and scale of stimulus exceeded that of the deep and persistent 18-month recession from January 2008 to June 2009.
The federal deficit increased from 4.6% of GDP in 2019 to 15% of GDP in 2020. That widening gap of 11.4 percentage points is the largest fiscal stimulus on record since WWII, and exceeded by a wide margin the 8.7 percentage points in the 2008-2009 recession.
The Fed’s assets more than doubled over a short time span of two years: from $4.2 trillion at the end of February 2020 to $9 trillion in the third week of March 2022.
Pathological negativity about the outlook for 2021 was amplified through the entire supply chain, as producers cut back on forecasts of product demand, and planned output rates were throttled back.
This knee-jerk reaction on the supply side was exacerbated by other disruptions, including tariffs from the previous administration, a crisis in the maritime shipping industry due to neglectful and abusive treatment of ship crews during Covid-19, and the re-emergence of regulatory constraints and roadblocks in the energy sector under the current administration. That includes the abrupt cancellation of the critical North American Keystone energy pipeline.
The Fed’s action to collapse interest rates and inject liquidity did not fuel an excessive household- or business-debt expansion. But the liquidity found the path of least resistance, and exploded into the speculative gaming “parlors” of SPACs, overpriced IPOs, cryptocurrencies, “coin” offerings, meme stocks, “pay for flow” cash flows and nonfungible tokens (NFTs). It’s a familiar tune: The Fed, the Treasury and the Securities and Exchange Commission (SEC) are unable to keep up with the liquidity whirling dervishes.
We are now witnessing the consequences of those speculative excesses. The Renaissance IPO ETF
is down 60% from a peak, and the Nasdaq Composite Index
of mostly growth and tech stocks is in a brutal bear market.
‘Excess employment demand’ is a myth
The jobs recovery since May 2020 has been stunning, but the “excess employment demand” narrative now being propagated by the Fed as a potential source of inflation is considerably exaggerated.
The Fed suddenly switched its primary focus from the broad U-6 measure of unemployment to the narrow U-3 measure. The gap between the two measures has declined sharply, from the March 2020 peak of 8.2 percentage points, to 3.4 percentage points in April 2022.
But the U-6 unemployment measure of 7% calibrates the current slack in the labor markets at 11.5 million, compared with 5.9 million with the U-3 measure. Thus, there is roughly a one-for-one match of the U-6 measure of unemployment in April 2022 with March 2022 job openings of 11.5 million.
However, we also know that many job openings are posted but are never filled, as employers for years have looked to hire “Tom Brady” qualifications for no more than an $80,000 yearly salary.
Then there is the multiverse of HR filters that need to be gamed by applicants to get beyond the HR bot gatekeepers. There are ghost job openings that are never filled. While nonfarm employment has recovered to within 1.2 million of the previous peak in February 2020, that “compared to previous peak” gap is not the correct measure of employment market slack[BB2] .
The “potential” gap in the employment markets would depend on the underlying trend growth rate in employment. Employment expanded at a compounded annual rate of about 1.6% over the 10-year period from the previous business cycle trough in February 2010, to the previous peak in February 2020.
We estimate a range for potential employment growth of payroll employment of 1% to 1.5%, which depends on both underlying population growth and changes in the participation rate. Adopting conservatively the lower potential growth estimate of 1%, that growth rate implies a potential gap of close to 5.9 million workers in February 2022, or about one half of the U-6 measure of unemployment.
The economy needs to add roughly 126,000 jobs per month to maintain 1% trend employment growth. To close the potential gap of close to 5.9 million workers from February 2022 to February 2024, the economy needs to add an additional 200,000 to 250,000 jobs per month.
Is the Fed really ‘behind the curve’?
It is ironic that the same recession doomsters in 2020 are now excoriating the Fed for being “behind the curve.” But is there any concrete evidence for that?
The Fed’s rate-setting committee adopted a quantitative 2% inflation target in January 2012. That target was amended as an “average rate of inflation” of 2% in January 2021. Over the 10-year period from the beginning of 2012 to 2022, the compound rate of change of the personal consumption expenditure deflator (PCE deflator) was 1.9%, below the Fed’s long-term target of 2%.
If inflation over the next year “conservatively” tracks near 4%, the compound rate of change of the PCE from 2012 to 2023 would still be only 2.1%.
Real wages expanded by only 0.55% a year in 2020 and 2021, compared with output-per-hour productivity growth 2.6% in 2020 and 2% in 2021. If the Fed were behind the curve, or there was “excess demand” in the employment markets, real wages would be expanding at a rate greater than productivity.
Relative prices versus inflation
We do not have enough evidence yet to determine whether the acceleration in prices that started in the first quarter of 2021 is an inflationary process, versus a relative price-wage adjustment.
Average weekly earnings for all private workers increased from $972 in the fourth quarter of 2019 to $1087 two years later, an increase of 11.8%. However, there is a significant shift in relative wages. Average weekly earnings for leisure and hospitality workers jumped 16.6% in that period. Education and health-care job earnings, in contrast, rose only slightly more than average.
Given the quantum increase in the risk of working in those industries, should there not be a significant increase in risk-adjusted pay?
Relative prices of energy and commodities prices moved up in 2021 due to the robust recovery in demand. The jump in demand collided headlong with the 2020 pandemic shock’s contraction of production capacity.
Energy and commodity prices ratcheted up further in 2022 due to war in Ukraine. In a market economy, relative prices and wages have to adjust to allow resources to move from one industry to another. That process takes time. There are no magical federal “resource reallocation impact payments.”
The problem is that wages and prices in other sectors have nominal downward rigidity. The net result is that we will observe general prices and wages rising for a period of time, even though the primary driver is a relative wage and price adjustment.
The yield curve’s head fake
The spread in 10-year and 2-year Treasury bonds turned briefly negative for two days in April 2022, before correcting and reverting to a normal positive spread.
However, this brief inversion was hailed as incontrovertible evidence that a recession was certain. But there was a similar inversion in August 2019. Where were the recession-mongers at that time?
While the 10-2 spread may have had some predictive “information content” from 1976 to 2007, the advent of large-scale asset purchases of Treasury bonds and mortgage-backed securities in October 2008, and subsequent massive trend accumulation of Fed assets until March 2022 to a peak of $9 trillion, or 36.9% of GDP, has effectively nullified this information content, per recent empirical studies from the New York Federal Reserve.
In other words, there was a structural break in the information content of the 10-2 yield curve indicator starting with the large scale asset purchases in October 2008. Updated studies indicate that it is the “near-term yield curve,” the current 3-month Treasury yield compared to the implied 3-month yield, two years in the future, that has the relevant information content.
Taking the 3-month to 12-month spread as a proxy for the near-term yield curve, that spread has steepened — from 26 basis points in December 2021 to 1.51% in the first three weeks of May, reflecting the substantial repricing of federal funds expectations for the second half of 2022 and in 2023.
The near term yield curve is generating a positive signal because the business cycle has sufficient positive fundamentals to absorb the expected normalization of the federal funds rate.
The Fed is threading the monetary needle
The Fed’s challenge is to wring out the speculative excesses that spilled over from the post-pandemic monetary stimulus without disrupting relative price adjustments or productive growth in the economy. It’s a tall order.
The bursting of some speculative bubbles is a necessary element of this process. Resources need to be reallocated from “gambling parlors” and energy-gobbling vapor companies and exchanges into supply-chain and energy infrastructure. This will involve some flattening of the growth trajectory similar to what we saw in 2001. There may even be a minor contraction of output.
However, the probability of a severe recession along the lines of 2008-2009 is extremely low. The main differentiator between the two outcomes — a “soft landing” versus a deep and persistent recession — is the role of banking-system leverage in terms of fuelling speculative bubbles.
The U.S. banking sector did not bankroll post-pandemic speculation. The Federal Reserve ran three rounds of comprehensive stress testing of the banking system in 2020, and restricted bank-capital distributions. The net result is that banks emerged at the end of 2020 with higher levels of capitalization than a year earlier. It was brilliant work in the trenches by the Fed.
The hit to household net worth in 2022 will be reasonably well-contained and the probability of a leverage-induced, domino-like wealth implosion is low. The good news is that what I call “weapons-of-mass-destruction-armed recession Martians” are fictional. There are more important supply-side resource allocation battles to be fought and won.
Brian Bethune is an economics professor at Boston College.