Is The Economy Making The Fed An Offer It Can’t Refuse?

By Michael L. Davis

Since this is the 50th anniversary of the movie "The Godfather," it's worth remembering that great scene where a gang war is about to break out and the Don's trusted capo, Clemenza, explains to the young Michael Corleone, "These things gotta happen every five years or so. ... It helps get rid of the bad blood."

Any similarities between Federal Reserve Chairman Jerome Powell and Michael Corleone are purely coincidental. Still, I wish Powell had Clemenza whispering in his ear.

The Federal Reserve has two problems. First, it has to figure out how to reduce the highest inflation rates we've seen since the early 1980s. Anyone who buys gas or groceries understands that problem. And anyone who knows much of anything about economics and finance understands that the Fed has to raise interest rates and tighten monetary policy in order to deal with that problem. It's already started. After the last meeting the Fed raised their target interest rate by 1/4 percent and promised more increases to come.

The Fed's second problem is much harder. They have to lower inflation rates while at the same preventing a recession.

Good luck with that.

To understand why the Fed has such a tough job ahead, let's talk about one of the most important concepts in all economics: stuff. It's the perfect word to describe the millions of goods that sustain our material lives — jet planes and jelly beans, barrels of oil and beach blankets are part of the stuff we need. Macroeconomists have lots of sophisticated metrics to determine when a recession begins — GDP growth rates, industrial production and so on — but at the end of the day a recession means we have less stuff than we would otherwise have.

And the Fed knows — or at least they should know — that right now they need to battle inflation in a world where we have less stuff. This is true for three reasons.

First, the pandemic dramatically disrupted the way we produce things. Supply chains were broken and businesses are now scrambling to establish new business-to-business connections. For example, the broken supply chain for automotive semiconductors led to the madness in the market for new and used cars. There are many, many such breaks in many, many such supply chains. Until these are fixed, we will have less stuff.

Second, labor markets are incredibly tight, with employers desperate to find workers. In fact, the Fed is forecasting that the rate of unemployment will drop to 3.5% and remain there through 2024. That's big if true, but it's probably not. Labor markets can be too tight. When it's hard to hire, it's hard to produce stuff. In fact, about 70% of the time when the unemployment rate goes below 3.5%, the economy enters a recession sometime in the next two years.

Finally, it's harder to make stuff when big parts of the world are shutting down. And right now, there is a major land war in Europe and a COVID lockdown in China. No one, including the Fed, knows how this is going to end up. But it can't be good.

All of these fundamental problems are real and well known. And now, after months of hopeful claims that inflation is "transitory," the Fed knows that inflation is real as well.

Clemenza may have been too pessimistic when he said "These things gotta happen." We can never be sure when or even if a recession will happen. The economy is way too complicated to forecast with any certainty. But the Fed is going to war against inflation in an economy that's already poised for recession. Don't be surprised if we start seeing headlines describing bloody economic shootouts.

Davis is an economics professor at SMU Dallas Cox School of Business.