By JAMES K. GALBRAITH
The market collapse and impending recession occur now, two years after the Federal Reserve began raising interest rates to “fight inflation”
The stock market crash haunts – perhaps – as the long-awaited sign of an economic recession in the US. For President Joe Biden's administration and Kamala Harris' presidential campaign, the timing couldn't be worse. For years, they tried to sell their economic government as a success story. With markets in decline and unemployment rising, this sale has become much more difficult – if not impossible.
The market collapse and impending recession occur now, two years after the Federal Reserve began raising interest rates to “fight inflation.” They are the direct but delayed consequence of this policy. So Fed policy is finally having its intended effect – more than two years after inflation peaked and began to fall, something that occurred for reasons unrelated to Fed policy. Federal Reserve.
Will a recession come now? For at least 40 years, an inverted yield curve on U.S. Treasury bonds has been a reliable indicator of recession in America. In 1980, 1982, 1989, 2000, 2006, and 2019, the interest rate on 90-day Treasury bills rose above the rate on ten-year bonds, and a decline followed within a year. In every case after 1982, the inversion ended when the recession arrived – but it arrived anyway.
This happens because when the Federal Reserve short-term interest rates rise, credit for business investments, construction and mortgages begins to decline. Why lend at 4% or 5%, or even more, with risk, when you can park your money in an investment, without risk, for 5%? Other factors, including the rising dollar (bad for exports) and the reset of interest rates on old loans (bad for credit card and mortgage defaults, notoriously in 2007-08), also play a role. Eventually, long-term rates start to rise and the inversion ends, but high long-term rates do more damage.
In this cycle, while the yield curve inverted in October 2022, no recession has occurred – until now. Countervailing forces supported the economy, including very large fiscal deficits, the payment of interest on a historically large national debt, and the direct payment of interest (since 2009) on very large bank reserves. The economy advanced despite the best efforts of the Federal Reserve to slow it down.
No more. Unemployment rose by nearly a percentage point last year and job creation is falling. The number of newly unemployed, newly employed part-time for economic reasons, and those not in the labor force but wanting a job increased by more than one million from June to July. Claudia Sahm's recession indicator – faced with a half-point increase in unemployment on a three-month moving average basis – is now being painted red. The Sahm rule has been valid since at least 1960.
In 2007, two co-authors and I studied the history of Federal Reserve in response to economic conditions. We found that, contrary to the rhetoric, after 1984 the Fed stopped reacting to inflation, which had disappeared close to zero. Instead, the Federal Reserve began raising short-term interest rates in response to a low or falling unemployment rate – the classic concern of employers who fear that their workers might demand higher wages or abandon them for better jobs.
More importantly, in the study, we tested whether the US presidential election cycle had a statistical effect on the yield curve after controlling for inflation and unemployment. We found – in every model we tried – that there was a distinct and strong effect: in presidential election years, the Federal Reserve follows an easier policy if Republicans keep the White House and a stricter policy if the president is a Democrat.
Specifically, our model predicted a tightening effect of about 1,5 points when the unemployment rate is low, with an additional 0,6 in a presidential election year when Democrats hold the White House, compared to an effect flexibility of 0,9 if the president is a Republican. Thus, in an election year with low unemployment, the expected fluctuation is around three percentage points in the yield curve.
On all key points, our 17-year model predicts the current situation. From the employers' point of view, unemployment has been disturbingly low. And a Democrat is in the White House. The yield curve is inverted by about 1,5 percentage points. So we now expect a flat yield curve if the president were a Republican and a positively sloped curve – the normal situation – if unemployment were also higher. Statistically speaking, the model explains why the Federal Reserve stubbornly refused to reduce interest rates despite the steady decline in the inflation rate.
Democratic presidents cannot blame anyone for such bias but themselves. For decades, they submitted to the Federal Reserve as if it were the institution that “fights inflation”. For decades, they have renominated Republican presidents: Alan Greenspan, Ben Bernanke and Jerome Powell. In addition to the seats, bankers and economists are strongly represented on the Board of Governors of the Federal Reserve and in regional banks in Federal Reserve.
These people may see themselves as nonpartisan high priests, but they are largely aligned with Wall Street and against the interests of working people. The result, predictably, is the recurring paralysis of progressive economic policy.
When Democrats took workers seriously – from roughly the end of the 1960th century until the 1930s – they understood that big finance had to be confronted and controlled. From the 1970s until the late 1980s, the United States had regulations and regulators committed to this task. But that dispensation was largely swept away in the XNUMXs, and since the Bill Clinton era, the Democratic Party has left the Federal Reserve in peace – and received a lot of money from Wall Street in return.
This presidential campaign has had many twists and turns. The economic shock of Federal Reserve – if it continues to develop – it will be another big shock. Given the possible effect in November, Democrats may now face another long period out of office. May they use it, if necessary, to reflect on the folly of bargaining for 30 years with big finance.
*James K. Galbraith is a professor at the University of Texas at Austin. Author, among other books, of Inequality: what everyone needs to know (Oxford University Press) (https://amzn.to/3sXLvDS).
Translation: Eleutério FS Prado.
Originally published on the portal Project syndicate.
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