We should expect strong jobs numbers at the start of a recession when inflation is high. Despite (subject to revisions) the second negative GDP quarter in a row, the White House and the Fed have reassured us that we are not in recession. In words echoed throughout government, Joe Biden previewed the negative GDP report with a prediction, "We are not going to be in a recession." The Fed appeared to echo Biden the same day (July 27), when Jerome Powell said, "2.7 million people hired in the first half of the year, it doesn't make sense that the economy would be in recession."
Sure enough, a strong jobs report last week lent support to the argument that the labor market is in such good shape that we cannot be in recession. But this argument ignores the economics of recessions, and the lessons of history. Policy-makers truly believing we are not in recession creates systemic policy risk because the normal recession playbook will be left on the shelf. As the unrecognized recession gets worse, the Fed and the Democrats will keep fiddling while Rome burns.
To be sure, there will be between now and the next election a large number of partisan recession deniers who will try to keep the word out of print in order to support Democratic candidates. There is no point trying to reason with such people of course, but at the Fed it also seems that a genuine belief has spread that we are truly not in a recession. That belief is, I believe, based on a simple conceptual error.
Inflationary recessions are reliably different from normal recessions, and their key attribute is that the labor data continue to look bullish throughout the first half of the recession. This happens for a simple and intuitive reason. When employers start to lose money at the beginning of a recession, they need to cut their costs as demand falls. With real incomes down more than 4 percent this year, and real GDP down two quarters in a row, demand is clearly falling. Wages tend to be hard to adjust downward, so in a normal recession, firms begin to adjust their costs by laying off workers.
But in an inflationary recession, firms' prices are going up faster than their wages, so real labor costs fall without the need for layoffs. With inflation running at about 10 percent, and wage increases up about half that, firms have already dramatically reduced their wage bill, relative to the rest of the economy. And if you add that wage increases tend to be focused on job switchers, firms that are hunkered down and not adjusting wages at all can cut their real wage bill right now by almost 10 percent just by treading water. Add to that the post-Covid difficulty in finding workers, and it is natural that this recession would see stronger labor-market data for now.
This pattern has happened before. Looking backward, we have had ten periods since World War II where we had two or more negative GDP prints in a row. All ten would eventually be judged recessions, even those that began with strong labor-market data.
Back in the 1970s, it was common for recessions to coincide with high inflation. In 1969, the recession began in the fall, but employment rose until the spring of 1970. In 1973, more than a million jobs were added after the recession was judged by the National Bureau of Economic Research to have begun. Once again, in the last recession of that decade, jobs data didn't turn south until halfway through.
The partisan recession deniers — that is, the Biden administration and congressional Democrats — have just passed a fiscal-policy bill that no rational economist would recommend enacting during a recession. The bill subsidizes inefficient energy production and pays for it with a slew of tax hikes. Indeed, even President Obama, in 2009, argued that you don't raise taxes in a recession. The reason you don't raise taxes in a recession is that doing so makes the recession deeper.
If the Federal Reserve were confident that we are in a recession, then it would continue to lift interest rates to fight inflation, but it would do so with the gentle touch of a brain surgeon's scalpel. Instead, comforted by low unemployment, it runs the risk of feeding the negative momentum from inflation and fiscal policy with harsh monetary policy. This also makes the recession deeper. In other words, the depression risks are higher than they have been in our lifetimes.
As the unrecognized recession gets worse, the Fed and the Democrats will keep fiddling while Rome burns.
Kevin A. Hassett is the senior adviser to National Review Capital Matters. He is also distinguished visiting fellow at the Hoover Institution and the global head of research at Affinity Partners. Hassett served as the 29th chairman of the President's Council of Economic Advisers beginning in 2017 and rejoined the White House in 2020 as senior adviser to the president.