This Business Cycle is Over

[I wrote this last night, when I was in a bolder mood, perhaps, and when the unemployment rate was 0.2% lower than it was this morning. After today's employment report, perhaps the Fed will pause, if only because there is evidence that the hard landing is already beginning to play itself out. But FWIW, here it is.]


Yes, the Fed will raise interest rates this month, and yes, there will be a recession, or at least a severe slowdown that nobody will mistake for a soft landing.

Having thought this through, I realize that the Fed has no wiggle room. Financial markets may have confidence in the Fed, but it’s not the financial markets that the Fed needs to convince. After the price increases that have happened during the past few months, if Bernanke wants to keep the inflation rate below 2% for the rest of his term, he has to say to companies like Procter and Gamble, “Don’t you dare pull this crap again!” He has to make them regret raising prices. If the slaves are to learn to obey, at least one of them must be publicly whipped. And the only way the Fed can conduct a public whipping is by whipping the whole economy until it bleeds. (Whether the NBER subsequently decides to apply the term “recession” is really not much of an issue.)

There is a loophole, however. It’s a loophole that I personally would be willing to apply if I were in Bernanke’s position. (Of course, if I were in Bernanke’s position, my inflation target would be a bit higher than the 1%-2% range conventionally attributed to Bernanke and others at the Fed – but that’s another story.) The loophole is this: you are permitted to raise prices if all you’re doing is passing through cost increases that result from supply shocks outside the control of domestic firms and workers. But there are a couple of reasons that Bernanke won’t apply this loophole. First, with the unemployment rate comfortably below 5% and nominal wage growth finally accelerating, Bernanke will not be willing to assume that the price increases resulted from supply shocks. Second, with corporate profits already at a record, US firms can (collectively, though not in all individual cases) afford to absorb the supply shocks: you don’t get to raise prices just to maintain profit margins that are (on average) already high by historical standards.

So the Fed will keep raising interest rates until one of two things happens: the inflation rate comes back down or the economy buckles. Both will happen eventually; the latter will probably happen first; indeed, the signs could be in place before the subsequent Fed meeting. Meanwhile, however, it will not do simply to hope that the tightening so far has been enough (even though, in my opinion, it has). The slowdown needs to be a virtual certainty. The newly employed slave driver cannot risk being unintentionally lenient.