It can be said that at one time—when inflation was out of con- trol—economic downturns, or recessions, had their value. That is because the decline in growth also was an opportunity to ratchet down the inflation rate.
During the Fed’s battle against inflation from October 1979 to May 2003, the Federal Reserve always wanted each cyclical peak and trough in the rate of inflation to be below the prior cyclical peak and trough, as can be seen in Figure 3.3. This strat- egy even had a formal, fancy name: opportunistic disinflation, which was coined by Laurence H. Meyer, a former governor of the Federal Reserve. What it was all about was waiting for reces- sions to opportunistically take inflation lower and then to use
preemptive rate increases to stave off any increase in the rate of inflation in the subsequent recoveries.
The Federal Reserve was quite comfortable with the notion of the next “opportunistic” recession taking inflation lower, toward the promised land of secular price stability.
But that is no longer the case. The next recession will be inop- portune. With the pace of price increases low and in check, the biggest risk facing the economy is not rising inflation, but the chance, albeit small, that a recession or a bursting asset bubble, or both, will shock the economy enough to cause a deflationary spiral.
The closer the inflation rate is to zero, the greater the risk that the downward price pressures that come with the next economic slowdown could tip the country into a bout of deflation. This means that future recessions are more threatening than those in the past.
What is needed to help stave off this threat is a buffer of infla- tion, a cushion against a fall in prices. That cushion—a slightly higher inflation rate than the Fed would have accepted in the
FIGURE 3.3 Opportunistic Disinflation
Taking advantage of the fall in prices during recessions—and keeping a cap on the lower inflation rate after recessions—helped win the war against inflation.
Source:Bureau of Economic Analysis.
past—is necessary so policy makers would not have to cut inter- est rates so precipitously that they would make investors look be- yond the risks of deflation in the financial environment, encouraging irrational exuberance.
How much cushion is needed? That is hard to say. But the 1 percent to 2 percent comfort zone of Fed officials, using the core (excluding food and energy) personal consumption expenditures deflator, the Fed’s favorite inflation measure, is too low. We think the Fed needs another full percentage point of protection.
Such a cushion would mean that a cyclical uptick in inflation is not categorically a bad thing and would not mean that in- vestors should conclude that the Fed has gone soft on inflation.
But unless financial markets and investors are prepared for this, a market sell-off is possible at the sight of Fed policy makers ac- cepting this extra inflation.
Adding to concerns about the next recession is the fact that it may be very hard to get the economy turned around once it has fallen into a slump.
It was not that difficult to revive the economy after it fell into a recession in March 2001, the first economic slump in a decade.
As noted earlier, by keeping interest rates low, the Fed helped turn homes into ATMs. With mortgage interest rates the lowest in decades, millions of Americans refinanced their mortgages, with most of them turning some of their rising home equity into cash that fueled the consumer spending that pumped up the economy again. The downturn lasted just eight months, less than the 10- month average for recessions since World War II.14
But it is difficult to see what sector of the economy can be lev- ered up in the next recession. Housing is not likely to act as a tonic this time. It is going to be a deadweight. With the home ATMs shut down, people will spend less and save more, which would be a big drag on economic growth.
At the end of 2006, there were convincing signs that the economy was slowing. The housing slump had begun. The pace of residential construction was decelerating and housing starts were well below their recent highs. Sales were also falling, and,
according to Fed policy makers, other indicators showed that the housing market would slow even further. Some analysts were forecasting a drop in home sales of 20 percent to 30 percent.
Although the price of a barrel of crude oil had retreated from its record high, retail sales were the slowest they had been in three years.
A slowdown does not mean a recession, so as this book was finished, the question of when the next recession would begin was still open. But it appeared that the next recession would have post-housing-bubble blues written all over it.
The next U.S. recession is also likely to be hard on the rest of the world, especially emerging markets. When that recession oc- curs, the rest of the world will have lost its best friend, which is the American consumer, so economic growth will slow globally.
Or, to use an old economists’ cliché, when the United States sneezes, the world catches a cold. This means the rest of the world’s central banks will have to be alert to cutting their own in- terest rates quickly to try to offset the economic drag from a drop in spending by millions of American consumers.
And when that recession is over there may be a surprise wait- ing at the other end—a jump in inflation that goes beyond the cushion that we think the Fed needs as a buffer against deflation.
Why? Because it may take a lot of stimulus to get the economy going again and the Fed will have to leave that stimulus spigot open long enough to be sure the economy is back on its feet. This could, however, turn out to be too much extra fuel for growth, set- ting off new inflationary pressures. We do not fear this at the mo- ment. But we mention it because it is in the forecast of Bill Gross, the chief investment officer at PIMCO and McCulley’s boss.