8 Signs that the Economy is Slowing
The recovery of the US economy from the COVID shutdown is several years old now, but how much longer will it last? Data on activity from various sectors of the economy give us clues regarding the short term prospects for prosperity. The Federal Reserve regulates interest rates and the money supply. Fed officials implemented a historic increase in the money supply in 2020 (see the top-left graph, below). The Fed cut the money supply in the past two years. Reductions in the money supply usually lead to recessions (marked by vertical gray bars in the graphs below).
Fed officials raise the Federal Funds Rate in the course of cutting the money supply, to control inflation. Hence, the difference between longer-term corporate bond rates and the short-term Federal Funds Rate falls leading into recessions (see the top-right graph below). These increases in short-term interest rates are neither inevitable nor purely financial. When the Fed pulls money out of short-term credit markets people in other markets could react by shifting funds- people who hold bonds could sell them to invest in higher short-term rates. Yet, short term rates typically rise above longer term rates leading into recessions- and this is happening right now.
Economist Paul Cwik argues that as the economy approaches a peak labor and capital become scarce- as entrepreneurs attempt to complete their current business projects. Rivalry for scarce labor and capital bid up the prices of these resources. Unexpected increases in costs in current business projects increases demand for short term credit among entrepreneurs. That is, demand for short-term credit increases at the same time that the Fed cuts it back on the supply of short term credit- to control inflation. There has been a decrease in the difference between long term and short term interest rates over the past year, as seen in the top-right graph. Increases in the cost of short term credit cause entrepreneurs to cut back on their operations, to lay-off workers.
Unexpected increases in the costs of resources and of credit naturally correspond to decreases in business confidence (see the left second row graph). Business confidence typically decreases leading into recessions, and has decreased since April 2022.
Higher costs and lower confidence usually correspond to less real economic activity. Industrial production surged in the latter part of 2020. Industrial production decreased since September 2022. Entrepreneurs build up inventories coming out of recessions, and run down inventories during recessions. Real inventories built up rapidly in 2022, but the growth rate of private inventories slowed dramatically starting in the fourth quarter of 2022. Slow growth in real private inventories indicate that the economy is transitioning from expansion to recession (see the third row left graph).
As industry slows, employers demand less labor. Average weekly overtime hours have declined since February 2022. The unemployment rate is technically still at a low level, but it has risen over the past year (bottom left graph). The Private Public Employment Ratio (PPER) has peaked leading into every postwar recession. The ratio of private to public employment falls going into recessions because private employers are more sensitive to economic conditions than are public employers. The PPER peaked in December 2022, and has been declining for over a year now.
No single statistic provides a completely reliable indication of short-term economic conditions. However, when multiple statistics suggest that a recession is imminent, we should ask if all these indicators could be wrong. What should the Fed do now?
The Fed committed a serious error by inflating the money supply in 2020 and 2021. The Fed has largely corrected this error. The recent contraction of M2 should restore the Fed’s credibility regarding long-term price level stability. Inflation persists mainly now because the rate of money velocity has increased since the first quarter of 2022. The Fed has indirect control over the total money supply, with a considerable time lag. Fed officials have no control over M2 money velocity.
Money velocity typically slows during recessions. If Fed officials were to continue with contractionary monetary policy they would risk having the money supply both shrink and slow at the same time. Price inflation needs to come down to a lower level, but not all in the next few months.
This would be a good time for the Federal Reserve to adopt a neutral policy position- steady money supply growth that is neither expansionary nor contractionary. If such a policy were adopted today it would reassure business investors and workers regarding future arbitrary increases in inflation taxes. That is, everyone would expect zero long term inflation. This also would mean that low inflation would persist in the short run, perhaps a year or two before actually reaching a rate of zero.
Unfortunately, Fed Chair Jay Powell announced today that he is “strongly committed” to a long term 2% inflation target and to short-term economic stabilization. Powell wants to hold the Federal Funds Rate steady for now, and will likely cut it later this year. Powell is also worried about uncertainty regarding economic growth this year, and he should be. Adopting a neutral monetary policy, one that targets zero inflation, means letting all interest rates adjust freely as the money supply grows. Of course, changes in money velocity and lags in the effect of Fed policy make it hard to estimate the neutral rate of monetary base growth. But neutral policy is easier, and less risky, than trying to use interest rates to achieve 2% inflation and maximum employment.