Trouble Ahead? Inflation And The Coming Recession
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Martin A. Sullivan, Tax Analysts’ chief economist, revisits the United States’ economic path to inflation and discusses mitigation efforts for a possible recession.

This transcript has been edited for length and clarity.

David D. Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Tax Notes Today International. This week: racing toward recession?

In March, we looked at how inflation was affecting the U.S. economy as the country started to emerge from the COVID-19 pandemic. Since then, the economy has been under even more scrutiny as inflation continues at its highest level in decades. At the same time, recession fears are beginning to mount.

Amid all this, the Federal Reserve has been raising interest rates and attempting to walk the narrow path between reducing inflation and not pushing the economy into recession.

So, can we tamp down on inflation while also avoiding a recession?

Joining me now to talk more about this is Tax Analysts’ chief economist and contributing editor Martin Sullivan. Marty, welcome back to the podcast.

Martin A. Sullivan: Hey, thanks for having me.

David D. Stewart: Why don’t we start off with just a bit of history, because the last two years have felt like 10?

How about you tell us about what things looked like back before the pandemic.

Martin A. Sullivan: Way back in the olden days before the pandemic, that is in early 2020, what we were looking at was an economy where things were growing nicely, but they weren’t growing at a nice pace. We had been spoiled with a nice 3 or 3.5 percent growth rate in the post-World War II period.

Since the Great Recession of 2007-2009, we were only getting 2 percent. On top of that, what was weird about that was we had a very expansionary fiscal and monetary policy.

So, the big concern at that time, was why do we have this slow growth? What can we do to get long-term growth going again?

By the way, the main reason for our slow growth over the long term is demographics. That U.S. population is slowing down and aging. Those 3 percent growth rates that we had experienced previously were attributable to large increases in the labor force, which we are not going to have in the future period.

But then, COVID-19 came, and everything changed.

David D. Stewart: I guess the other history lesson to lay the groundwork for our discussion is when COVID-19 hit, there were a lot of interventions. Could you tell us about some of the big issues that went on during the heart of the pandemic?

Martin A. Sullivan: Sure. When COVID-19 struck, first of all, the degree to which it devastated the U.S. economy was just unbelievable. We just talked about the Great Recession of 2007-2009. The job losses for the pandemic recessions were three times larger. So the shock was just incredible.

To the credit of Congress and the president, the policy response was rapid and large. Historically during recessions, the U.S. government has been very slow and reticent to come. So we economists were really happy that they had responded so quickly and with such force.

That happened on the fiscal side with all the spending and tax cuts, and it also happened on the monetary side with the Fed greatly increasing the money supply.

David D. Stewart: All right. With all of this greatly increased money supply and all of these interventions, we seemed to have possibly overshot, and now we’re looking at inflation. Can you tell us a bit about what we’re seeing out there in terms of inflation?

Martin A. Sullivan: Well, no good deed goes unrewarded. What happened was we were so good at addressing our contractionary economy that we kind of overstepped. Where that occurred was with the third set of stimulus checks, which occurred very early in the Biden administration during the American Recovery Plan (ARP).

If you look back at the data, even I didn’t realize this at the time, there really wasn’t any inflation until the beginning of 2021, almost a full year after COVID-19 started. Many months after the first two big stimulus plans came through.

2021 hits, the ARP stimulus checks come in, and all of a sudden, inflation pops up out of nowhere after it had been gone for 40 years.

What we also saw on the data, again, Congress was so generous, that even though we were in a severe recession where 25 million jobs were lost, income actually went up. How could that possibly be? The reason was, although income from wages and profits was down, it was more than made up for by the stimulus payments and the payments to businesses.

Of course not everybody was, but in the aggregate, people were better off. On top of that, they didn’t have all the normal places where they could spend it. The service economy was down and out. The goods economy was booming, but then they ran into supply chain problems.

We have this situation of severe contraction, but income goes up, demand for services go down, demand for goods go up. All of these magnitudes are very large.

All of a sudden, we’re in a maelstrom of major economic forces pushing us back and forth all over the place.

Many stories come out of that, for example, the chip shortage or supply chain shortage. But the big story that comes out of that, of course, is the reemergence of inflation, which is the dominant issue right now, I think, for the U.S. economy.

David D. Stewart: Is it a direct link between that stimulus payment and the rising inflation? Any of the expansionary policies of the previous years, are they factoring into this, or is it really just a one-to-one relationship?

Martin A. Sullivan: Well, I don’t have a model, but I have a story.

David D. Stewart: OK.

Martin A. Sullivan: The story is, we really didn’t see inflation until this third stimulus payment to the ARP, which happened to coincide with the Biden administration, so he gets all the blame. Also, the Biden administration denies that the ARP was the cause of it. But if you just eyeball the data, it’s just incredible.

It seems the story I’m telling you, not a model, is that the first stimulus right at the onset of the pandemic in the spring of 2020 was very good. The second which came at the end of 2020 was also good, kind of the icing on the cake. But the third one, that was a couple trillion dollars too much for the U.S. economy to digest.

Where you also see it in the data is, out of nowhere, if you look at bank accounts, what people keep in their checking accounts, the data up to that point was just flat. Then all of a sudden, it tripled.

The story behind that is, we’ve got lots of money, but we’ve got nowhere to spend it. I was trying to buy a new stove from my house, because my stove broke. I had to wait six months.

Kids were waiting six months for their video games.

David D. Stewart: I did eventually get my PS5.

Martin A. Sullivan: Thank you, sir. Thank you.

David D. Stewart: But I’m still waiting for my car.

Martin A. Sullivan: Well, there you go. That’s what was going on. We had the cash. The supply chain just couldn’t get it to us fast enough.

David D. Stewart: Now that we have inflation, what do we do about it?

Martin A. Sullivan: Ah, well, the way I like to think about it is: [L]et’s try to identify what caused the inflation. We went over a little bit, but let’s just make it a little neater.

Certainly, we had a demand side push, an increase in aggregate demand, caused by all those checks coming in to the U.S. consumer, so there’s a demand side component. Certainly, we had a supply side problem, with oil prices going up, housing prices going up, video game prices going up, supply chain disruptions, energy prices going up. We have demand surging, supply contracting, and when demand exceeds supply, prices go up.

A third component to this is that depending upon how much of a monetarist you are, changes in inflation are related to the amount of money in the economy. That is, how accommodated the Federal Reserve is.

The Federal Reserve, to their credit, when all hell broke loose with COVID-19, injected massive amounts of money into the financial system to prevent the financial collapse. That’s a good thing. If you go back and look at the data, we came very close to a financial collapse, and it is entirely because of the Fed’s actions that we avoided it.

But here’s the hangover. They have all of this money sloshing around in the economy and that increases prices.

Now, if those are the causes, can we put them in reverse? Well, if there’s too much aggregate demand from too much government spending or too little taxation — now I’m going to say something that’s sacrilegious but it’s economically true — the right response might be to increase taxes. Increasing taxes would reduce all that money that we have in our bank accounts that we’re dying to buy more stuff with and take the pressure off of prices.

Obviously, I’m not running for office, so I can say things like that. But let me put it to this way. What we should be thinking about is not making matters worse by having more tax cuts right now.

On the supply side, and that’s the real wild card here. For example, with supply chain disruptions, you have to think that over time, the private sector is going to figure that out. It’s going to be very difficult, but they will figure it out.

On energy, well that’s an absolute wild card. There’s no short-term solutions for the supply of oil and natural gas, but there are a lot of supply problems of course, with the war in Ukraine or any other natural disaster like a hurricane that might shut down a refinery in the United States anytime soon.

We also have housing inflation. In the last 18 months, the average rental went up 30 percent in the United States. There’s not going to be any short-term increase in housing supply that’s going to make that all better anytime soon.

The supply side is problematic, and there’s probably not a lot we can do about it, especially in the short run.

On monetary policy, the third component, of course, you’ve heard about the Fed raising their discount rate by what people call large amounts. I personally think they’re going to have to go up a lot larger than that.

They’re also reducing their balance sheet, which is another way of saying they’re decreasing the money supply. They’re starting to do that. Monetary policy is headed in the right direction.

The possible good news scenario is, well, we have fiscal policy, which kind of stays level. The supply chain problems figure themselves out. Oil prices stabilize to something we can tolerate, let’s say $3.50 a gallon for gas or something like that. Rents, people start going back to the offices and stop working at home. Then the Fed’s monetary policy starts kicking in, so that inflation goes down.

If all you care about is inflation, all of those things I just mentioned are good things. But there’s always this trade-off that you mentioned at the outset, which is, if we’re going to do all that stuff to control inflation, we really run the risk of creating a very large reduction in unemployment and in output, which some people call a recession.

David D. Stewart: Yeah. To that point, I guess the obvious question is, is it possible to thread this needle? You need to tamp down inflation, if this is what’s important. How do you make sure you don’t overshoot and cause more pain in the long run?

Martin A. Sullivan: Even if this little island between inflation and recession existed, it’s very hard for the Fed to steer the course. I’ve heard the analogy like when you’re adjusting the shower in a hotel, you’re not used to it, and you turn it on. “Oh, it’s too cold.” So you turn it all the way up high. “Oh no, now it’s too high.” You turn it all the way back down. Even if there was that perfect economic temperature out there, it’s very hard to steer toward it.

But probably even the bigger or more pessimistic, even more troubling aspect is, there may be no middle ground here. The central point about curing inflation, and you’re too young to know this, is that you have to inflict pain. It’s not all candy bars and whipped cream to get rid of inflation.

That’s why it took, let’s just say a decade, from the early ’70s to the early ’80s to cure inflation, because nobody wanted to inflict that pain. No politician wanted to increase taxes. They just floundered around. There was no politically acceptable solution until the unelected head of the Federal Reserve, Paul Volcker, in October of 1979, just slammed the brakes on monetary policy, and that’s what cured inflation.

But it took 10 years for people to bring themselves to do this. So there must be pain. Whether that pain comes naturally from a natural recession, from some other cause, or it comes from policy, you’re going to need a recession, a major slow down in economic growth to bring inflation in line. At least, that’s what all the history and all the theory suggests.

To hope for the so-called “soft landing,” of course we all hope for that, but it just seems impossible or it seems very unlikely that could ever occur.

David D. Stewart: You’re talking a lot about the Federal Reserve taking action. What could be done, assuming there was the political will to deal on the tax side. Because as I see, the Federal Reserve is taking a sort of a broad approach, cutting back on the money supply. Are there more targeted things that could be done in taxes to maybe navigate the ship through the shoals here?

Martin A. Sullivan: As the pure, cold-hearted economist that I am, I would like to see tax increases. OK? But that’s not going to happen.

Having said that, perhaps all we can best hope for in any political environment, and not blaming Republicans or Democrats here, is do no harm. Don’t make things worse.

But what actually you’re seeing, you see it right now in the United Kingdom, where there’s a two-way race for the prime ministership of U.K. The candidate who’s in lead [Liz Truss] says, “We need to cut taxes to address inflation,” while the other candidate [Rishi Sunak] who’s behind and will probably lose is saying, “I want to cut taxes, but we have to cure inflation first.”

It looks like in the U.K., if the polls are correct, we’re going to have a major tax increase to address inflation, which is the exact opposite of what most of economists will tell you is the right thing to do.

Back home here in the good old United States, I think we’re up to 20 or 25 U.S. states that have significant tax cuts on their agenda to provide relief to the citizens for inflation. I perfectly understand why you would want to do that from a political point of view. But from an economic point of view, it is trouble waiting to happen.

One way of thinking about it is, if the states start giving away all these tax breaks and expanding the economy at the same time the Fed is trying to increase interest rates and contract the economy, well, you have one foot on the gas and one foot on the brake at the same time.

What’s worrisome is the Fed, in order to get inflation under control, if the states are being so generous, they’re going to have to raise interest rates even more than they might have had to do otherwise.

So we’ve got a really crazy situation here where we can’t even agree on whether we should be going up or whether we should be going down, and that is a bit unsettling.

David D. Stewart: I guess the other thing going on in the United States is in Congress, they’re trying to negotiate some version of the Build Back Better Act. In this current environment, what should we be seeing there?

Martin A. Sullivan: It is another example of the massive confusion about where we should be going directionally with our fiscal policy.

Now, fiscal policy has lots of different dimensions. We care about global warming and the incentives to reduce that. We care about income distribution. We care about infrastructure. All of this stuff is packaged inside the Build Back Better Act and all of its different versions. The hot story of last week was when Sen. Joe Manchin, D-W.Va., essentially vetoed the bill’s approval in the Senate by saying he wasn’t going to vote for it.

David D. Stewart: Just a note before the interview moves on, we recorded this on July 26, and that was a day before a deal between Senate Majority Leader Chuck Schumer, D-N.Y., and Manchin was announced.

Martin A. Sullivan: What was puzzling about his reasoning is inconsistency. Let me just very briefly explain that. What he did say, according to several news reports, was that he was concerned about inflation and he wanted to see deficit reduction.

This economist says, “Well, that’s good. Give points to the senator, because that’s the way you stop inflation is that you reduce the budget deficit either through higher taxes or through less spending.” That was the very final version that apparently was negotiating.

But then, the next day he got on local West Virginia radio and said he couldn’t even support that because he was concerned about inflation. We really can’t figure out where he’s coming from.

But I think his confusion is sort of widespread throughout Washington and throughout the country. We don’t have a clear understanding of where we want to go. The original Build Back Better Act, six versions ago, that the Democrats originally endorsed, was generally revenue neutral. I have several fine points about it that I believe it would have been a little bit stimulative.

But given that it was generally revenue neutral, that it would not increase the deficit, and that it was building infrastructure, which increases aggregate supply, that you could object to it for all the reasons you might want to object to it. You want to promote coal because you’re from a coal state, or you don’t like redistributing income, or you don’t like taxing corporations or whatever it is. That’s all fine, but you really couldn’t get super upset about it because of its macroeconomic effects on inflation.

That became Senator Manchin’s central excuse, when really it was a side show to what was really going on with that bill.

David D. Stewart: At the same time that we’re dealing with these inflation issues and other concerns, we’re also watching energy prices higher than they generally are. They’re fairly painful to many people. What effect does that have on the economy and what needs to be done policy wise?

Martin A. Sullivan: Well, the first thing it does, and something we don’t stress enough, is that we have a tremendous cloud of uncertainty hanging over everything, so businesses can’t make good projections about the long term. If I want to build a power plant or an oil refinery, it’s very difficult to know what to do in this environment.

I think what it is doing to us is it is telling us there’s not really much we can do about the price of oil.

But I will point out two things. One is that the European Union and the Russians are probably going to significantly reduce their gas supply into Western Europe, either the Russians cutting it off, or the Europeans preventing it from coming in. That’s going to drive up natural gas prices to scary levels.

Also, we have the Strategic Petroleum Reserve. People forget about this. Biden did a good thing. The typical way you measure oil production and consumption is in millions of barrels per day. The United States is the world’s leading producer of crude oil, and we consume about 10 million barrels a day.

What Mr. Biden said was he’s released 1 million barrels a day from the Strategic Petroleum Reserve into the market. That’s a 10 percent increase in supply relative to our consumption. That is a 180-day program that is scheduled to expire in November. If that actually does happen, that’s going to increase prices.

I think the intermediate term “energy outlook” may not be so bad, but we have to get through this winter. Western Europe has to get through the cutoff of the natural gas, and we may have to get through the cutoff of the Strategic Petroleum Reserve.

David D. Stewart: All right. I have one thing that’s sort of rattling around in my mind. It’s a term that people have been using. It’s something that happened before I was born — I was born in 1980 — and people are talking about we’re looking at a possible recession, but inflation at the same time. I’m hearing this term “stagflation.”

First of all, what is that dynamic? What sort of havoc does that wreak?

Martin A. Sullivan: There were so many bad things in the ’70s that you missed, and that was one of them. We generally talk about there being a trade off between inflation and unemployment. So, “Oh gee, if we can get unemployment down, well, we might have to pay the price of high inflation and vice versa.”

The bad news of the ’70s was we got both at the same time. We got high unemployment and high inflation. You used to add those two numbers together and they called it the “misery index.” That’s something again, it’s like disco, that’s also from the ’70s.

There is that possibility when you have these types of supply side shocks in 1973-1974, we had the Arab oil embargo. In 1979 we had the Iranian Revolution. Both of those things spiked up energy prices and caused stagflation. Now to the extent that our current situation is caused by supply side problems like energy prices, like labor market shortages, something we haven’t talked too much about, there’s not much that we can do about that.

David D. Stewart: I guess it’s time to look forward and attempt to predict the future. First of all, do you see a recession on the horizon? Is this inflation problem going to be with us the way that it was in the seventies?

Martin A. Sullivan: I hate to use the word recession, because that implies bright lines. But if we’re going to cure this inflation problem, we’re going to have to have a slow down in economic growth. We’re going to have to have a reduction in employment. We’re going to have to have some pain. Unless we do that, this could drag on for years and years and years.

Now, most folks and most professional forecasters are optimistic, but I would put that caveat in there. Is the Fed going to wimp out at the first signs that these anti-inflationary measures that they’re taking are causing real pain? We’ll have to wait and see.

But if we can get over this episode, then we can go back to where we were when we started our little chat, Dave, which is we’re on that long-term growth path, where we have low interest rates, low productivity gains, low economic growth because of demographic factors, but at least we don’t have chaos like we have now.

David D. Stewart: Well, all right. I guess we can all hope for a new boring.

Martin A. Sullivan: Yeah, that’s right.

David D. Stewart: Marty, thank you so much for being here. This has been great.

Martin A. Sullivan: Thanks for tolerating me.

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