The Economy Hangs By A Thread, Today The Fed Is Likely To Pull It Tighter
Virtually all of Wall Street and most seasoned “Fed Watchers” expect the US Federal Reserve to raise interest rates by another one-quarter percent when they announce their latest interest rate decision this afternoon. If so, this will be the eleventh rate hike in just sixteen months and the most rapid rise in history on a percentage basis. The Fed will have taken its primary interest rate from less than one-quarter percent to now five and a half percent.
The Fed behaves like this is a strong economy, and its chief mission is to curb runaway inflation. More precisely, the Fed believes that the current economy is much like those economies of 50 years ago. A time when a virtuous cycle, when expanding production leads to higher salaries, leads to rising prices (inflation).
Does anyone believe that this economy is so strong that price inflation is driven by increasing production, leading to higher worker income, leading to inflation? I doubt it. Most consumers, at least according to the surveys, believe that incomes are flat, and consequently, inflation is likely to decline. In its monthly survey of consumer inflation expectations, the University of Michigan reports that inflation expectations have fallen from 5.4% in March 2022 to currently 4.2%. From the consumer’s perspective, inflation is declining, not rising, as the Fed suggests.
The strategy that the Fed is using was described by William McChesney Martin, former Fed Chairman, as “taking away the punch bowl as the party gets started.” As the longest-serving Fed Chair in history, Martin had a real feel for the ups and downs of the economy. His point was that just as a good host manages a party by removing the alcohol (the punch bowl) as the guests begin to get rowdy, the Fed needs to cool off the economy when it overheats. The Fed removes stimulus primarily by raising interest rates.
So is that where we are? Is the economy beginning to “rock and roll” as things start to get hot, and we’re overproducing so much that it’s driving prices higher? I doubt that many would prescribe that thinking.
So, exactly how is the economy performing? Is it overheating, as the Fed suggests? Or, on the contrary, are there indications that we may be heading into a recession? Like many complex issues, this question has at least two sides.
If the analysts are correct today, the Fed will raise rates by one-quarter percent, implying that the economy is performing strongly. Tomorrow the Bureau of Economic Analysis will likely report that our Gross Domestic Product (GDP) expanded by 1.8% to 2.0%. And just like that, everyone will breathe a sigh of relief. The Fed’s strategy will have worked; they can continue to raise interest rates without sending us into a recession. At least, that’s how things appear from the production side of the economy.
Gross Domestic Income (GDI)
But, there is more than one way to see this economy, and the other side does not look so rosy. How is the country doing from an income perspective? It’s one thing to say that we’re still making things (GDP/production), but that means little if our income is slowing. There’s a measure for that: the Gross Domestic Income (GDI). Like GDP, the GDI is published by the Bureau of Economic Analysis monthly, but with a month’s delay.
As anyone who has run a monthly budget will tell you, the income statement is vital to understanding how you’re performing. From a household to the largest corporations, how much money we make is the principal driver of economic health. It’s ironic, therefore, that this measure of our nation’s financial performance is ignored by so many. Nonetheless, most of us, including the Federal Reserve, have not noticed that from an income perspective, our economy is already in a Recession.
The nation’s income declined into negative territory by Q4 2022 and was negative for Q4 2022 and Q1 2023. Arguably we were in recession (at least from a GDI perspective) in both quarters.
GDP Plus
If you’re following the logic, this puts us in a situation where one indicator is positive (GDP) while the other (GDI) is negative — a sticky situation.
Fortunately, the Philadelphia Branch of the Federal Reserve has come up with a way to reconcile just such a difference. It’s called GDP Plus, and it’s their current way of presenting the best picture of the economy. GDP Plus combines the economic measures of production, and income, providing a comprehensive result.
Currently, GDP Plus indicates that we are in a recession now. It means that the Fed’s efforts to slow the economy and thereby slow inflation have worked. Or at least the first part, slowing the economy, is working. Continuing to raise interest rates will only slow the economy further.
As any good finance officer will tell you, it pays to look at all of the components of an enterprise, income, and production to get a complete picture. Today the Fed is only watching one aspect of our country’s finances.
https://www.philadelphiafed.org/the-economy/macroeconomics/131104-bank-introduces-new-measure-of-gdp
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