[Updated on July 11]

With surging inflation and looming recession in the US, economists and policy-makers have begun a belated round of soul searching about what went wrong. The critical mistake appears to have been conflating a suppression with a depression. Other mistakes followed from this fundamental misconception.

When the pandemic hit, policymakers adopted the 2008 experience as the template and decided to ‘go big or go home’. This was not entirely without cause. The decline in GDP and employment was far more acute in the 2020 pandemic than it had been in the Great Financial Crisis of 2008-2009. Indeed, GDP declined by twice as much in early 2020 as it had during the Great Recession.

Therefore, the Fed and the Biden administration deemed a much larger stimulus and fully accommodative monetary policy to be appropriate. Unfortunately, this involved an error of construction, the mistaking of a suppression for a depression.

We define a depression as an economic downturn linked to a large decline in house values. When this occurs, households cannot use their homes as collateral for borrowing, as their dwellings are often worth less than the amount owed on the mortgage. Instead of borrowing more, homeowners are forced to slowly pay down their mortgages and re-establish positive net worth in their homes. The economy struggles as consumer borrowing is depressed for the many years borrowers require to regain home equity.

In such cases, as in both the Great Depression and after 2008 (which we refer to as the ‘China Depression’), the US Federal Reserve Bank reduced the benchmark Federal Funds Rate (FFR) effectively to zero percent, not for months, but for seven years. Because consumers were unable to refinance due to impaired home values, such low interest rates had no notable effect on house values, stock prices or inflation in the decade after 2008.

By 2017, however, home values had recovered, and by the time the pandemic hit, consumers were prepared to borrow and spend.

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The term ‘suppression’ is not commonly used in economics. Indeed, the profession does not distinguish among recessions, depressions or suppressions.

As used here, a suppression means a reversible outage, an exogenous restriction on economic activity. In this case, the suppression arose from pandemic-related lockdowns and spontaneously from the public’s fear of infection were they to leave their homes. None of this had anything to do with the business cycle.

To illustrate, consider a hypothetical teenager, Bobby. Imagine Bobby had the flu, and a doctor gave him stimulants and medicine to feel better. After a while, he would recover and gradually rejoin society. This describes a typical recession.

Now imagine instead that Bobby’s parents had grounded him and confined him to his room. At the same time, those same parents gave him $50 and some amphetamines to stimulate his activity. Bobby, when released from his captivity, would come out amped up and ready to spend.

That is the difference between suppression and a recession, and it illustrates why the economy rebounded much more quickly than the Federal Reserve expected.

By mistaking a suppression for a depression, the US government set both fiscal and monetary far too loose.

Consider fiscal policy. At the beginning of the pandemic, in Q2 2020, the output gap (the difference between potential GDP and the actual output of the economy), rose to $2.1 trillion or about 12% of GDP. This prompted the government to borrow $3.4 trillion, half again as much as the gap, to distribute as stimulus payments and other support to the economy.

Were this a depression, the gap likely would have persisted. But as it was an outage — a suppression — the gap closed immediately, down almost 60% by the next quarter. By year-end 2021, the gap had effectively disappeared. Meanwhile, the government had continued piling on debt, such that Federal debt today is nearly $7 trillion, 30% of GDP, higher than it had been prior to the pandemic. This is a colossal amount of borrowing in a very short time. In an ordinary year, government borrowing might increase by 2-3% of GDP. The pace of debt accumulation from the start of the pandemic was almost an order of magnitude higher, representing the most radical increase in US borrowing in its peacetime history. This was a grand and perilous experiment in US fiscal policy.

Unsurprisingly, such debt-fueled stimulus led to a rapid and unsupportable increase in demand. Since the US economy could not produce sufficient goods to cover the stimulus, imports soared, leading to record trade deficits and bottlenecks at ports like Los Angeles and Long Beach. Inventories were stripped across the economy. New and used cars were scarce. Items normally available in demand, for example bicycles, became rationed, with retailers hoarding items like the spare parts necessary to run their maintenance operations. A flood of stimulus money blew up the supply chain.

With the stimulus winding down, this process has begun to reverse. Retailers like Wal-Mart and Target reported record increases in inventories in Q1 2022. Previously placed orders arrived just as the stimulus began to wear off. Where inventories had been scarce, suddenly retailers had too many goods in their warehouses. Mark-ups are being replaced by discounts. After the party of cash handouts to the public, the hangover is now on us.

On paper, the roll-off of the stimulus should lead to a technical recession with a decline of perhaps 4% of GDP. Accordingly, GDP declined by 1.6% in Q1 and a number of forecasters see negative growth in Q2 as well. The Federal Reserve Bank of Atlanta, for example, projects Q2 GDP growth at -1.2%. If expectations of decline prove correct, the first half of the year would qualify as a recession by the two negative quarters standard.

Such a technical recession need not cause high unemployment. With the end of World War II, US government spending collapsed, leading the economy to contract by 11% in 1945, but with almost no impact on employment. Brisk growth resumed the following year. If that precedent applies in the current case, growth might resume in the second half of 2022 as the effects of the stimulus wash through the system.

However, there are two complicating factors. The first of these is high oil prices and, even more notably, high gasoline and diesel prices. The last time the world saw such high prices, from 2011 to 2014, Europe slumped into a five quarter recession and the US struggled with ‘secular stagnation’. The story may be repeating itself now, with 55% percent of the US public believing that the country is in recession already, paired with consumer sentiment at its lowest level in seventy years. Both these polls reflect a public under considerable stress from inflation, most notably in energy prices. Ordinarily, such sentiment would be linked to looming recession.

High oil prices often occur in the context of rising interest rates, and this time is no different. As the Fed misdiagnosed the pandemic downturn, monetary policy was set far too loose, contributing to the worst inflation in forty years. As is typical in such cases, the Federal Reserve has started to raise interest rates to suppress the demand for money and thereby reduce inflation.

Not everyone believes the money supply and inflation are linked. In December 2021, Federal Reserve Bank chairman Jerome Powell told a House committee that the once-strong link between the money supply and inflation “ended about 40 years ago.” Powell’s beliefs rest upon the relationship of the money supply to inflation from the start of the Great Recession. From late 2007 until the start of the pandemic, M2 had risen by 60% more than GDP growth, and yet cumulative inflation over that 12 year period was only 20%. The Fed could print money with impunity, it seemed.

Standard economic theory, by contrast, attributes inflation principally to growth in the money supply. The Nobel laureate economist Milton Friedman famously said that “inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” M2 is a widely used measure of the quantity of money, and it has increased by 39% since the start of the pandemic.

If Friedman were correct, we would expect prices to rise by the increase in M2 less the increase in GDP. GDP has risen by 5% since the beginning of the pandemic, and therefore we might expect prices to rise cumulatively by 34%, all other things equal.

There does, however, appear to be a lag between an increasing money supply and inflation. As the website of the St. Louis Federal Reserve Bank notes:

During periods of underutilization, when the money supply is increased, there will be an increase in output; however, as those idle resources are utilized—as idle factories return to production and the labor market begins to tighten up—an increase in the money supply will be reflected in the price level. This is inflation caused by too much money chasing too few goods.

And this indeed appears to correlate to the historical record. During inflationary periods of the past sixty years, observed inflation rates lagged increases in the money supply. However, several quarters after the deployment of monetary stimulus, the trend line took a ‘right turn’, as can be seen on the graph above, and inflation continued without further monetary easing. Such inflation can continue for several years as prices catch up with prior increases in the money supply.

Interestingly, observed inflation can often surpass increases in M2. After 1975 and again after 1983, cumulative inflation amounted to 5-10 percentage points more than the growth of M2 adjusted for real GDP growth would have suggested.

With this model, commonly referred to as the Quantity Theory of Money, we can consider the nature of monetary policy resulting from the pandemic. As with earlier episodes, recent monetary easing did not, in the initial phases, lead to the level of inflation predicted.

However, we appear to be at the inflection point now, as the trend line turns to the right, with high inflation even in the absence of further monetary accommodation. The vast increase in the money supply is beginning to make its way into the economy.

The increase in the money supply has been simply staggering, more than twice the relative size of monetary accommodation in the early 1970s associated with the first oil shock, and three times the size associated with the second oil shock in the last 1970s. Both of those episodes led to brutally high levels of inflation. The current bout could be 2-3 times worse if the model holds up.

Thus, if precedent applies, inflation could average 2-3 percentage points per quarter, 8-12% per year, for 18-24 months, and possibly substantially longer. Alternatively, inflation could be more acute over a shorter period. By implication, the Fed would have to continue to raise interest rates to counter inflationary pressures, something which has inevitably triggered recessions.

Not all analysts are so pessimistic. Unemployment remains low, and although initial unemployment claims are rising, they are rising slowly and remain at modest levels. Real estate inventory, although rocketing up, remains low by historical standards. In addition, consumer finances remain in comparatively good shape, allowing for a loss of purchasing power due to high gasoline and consumer prices. As a result, many economists anticipate ‘stagflation’, sustained high inflation with mediocre real GDP growth. This is unpleasant but not necessarily a disaster.

There are worse scenarios. The model suggests that monetary accommodation has been so great that the US could see both inflation and recession at the same time. Forget stagflation, the US could suffer a ‘Nor’wester’, an economic gale which blows the trendline down and to the right, pummeling the country with stiff price increases even in the face of declining economic activity driven by interest rate hikes. In fact, this is the outcome predicted by Kalshi, an online marketplace to place bets on economic outcomes. Participants expect a recession in 2022 by a ratio of 82:19, but at the same time anticipate elevated inflation above 8%.

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It is hard to overstate just how radical both fiscal and monetary policy have been under the Biden administration. The response to the pandemic was not at all the measured sort seen over the last forty years, or even during the excesses of the late 1960s and 1970s which brought intolerable stagflation at the time. The Federal Reserve and the Biden administration have deployed a scale of fiscal and monetary expansion never before seen in US history during peacetime, not by a substantial margin.

The implications are becoming clear. The fiscal stimulus is wearing off, which could lead to a recession by itself. At the same time, the vast increase in the money supply has begun to manifest itself in consumer price inflation.

It seems likely that the US will experience a technical recession in H1 2022, or barely escape it. After that, consumers will have to reckon with rising interest rates and oil prices unlikely to retreat much for the balance of the year. We would ordinarily expect such developments to lead to a recession starting in the next twelve months or so.

Time will tell. Notwithstanding, it is hard to avoid the sense that the reckoning is upon us.