Is the Federal Reserve Lucky or Good?
Posted Sep 27, 2023
The business cycle is defined as the ups and downs in the level of business activity, as measured by the Gross Domestic Product — the monetary value of all goods and services produced within the U.S. Notable business cycle historical events we all learn about include the Great Depression in the 1930s, Stagflation (employment and inflation) in the 1970s, and the Financial Crisis in 2008. The COVID-19 pandemic disrupted global economies in ways nobody could have predicted and many wondered what kind of business cycle would result in the short and long term.
A period of under-employment of resources, like labor, has a social cost, and the inability to produce enough goods and services creates inflation and the erosion of consumer purchasing power. Now, the U.S. Federal Reserve Bank has a dual mandate: full employment and stable prices. Will it achieve its mandate post pandemic?
The Pandemic caused a significant downturn in the level of business activity in 2020. GDP dropped 29.9% in the second quarter and unemployment increased to 14.7% in response to the economy being shut down. To counteract long-term impacts, the Federal Government offered direct assistance to business and consumers. Examples include deferring student loan payments and the Paycheck Protection Program. Consumers and business entered the pandemic in reasonably good financial health and, combined with the government programs, created a “V” shaped economic recovery. Post pandemic, the economy experienced a sharp increase in demand, or an upswing in the level of business activity. During the second quarter of 2020, GDP increased by 35.3% and the unemployment rate declined to 6.3%. As the economy opened, demand not only increased but shifted from hard goods, such as furniture and home remodeling, to services, such as dining out and travel. Supply bottlenecks and labor shortages caused prices (inflation) to surge. In the second quarter of 2020 inflation was near zero and increased to a peak of 8.93% in 2022.
To combat inflation, the Federal Reserve relied on traditional policy tools and sharply increased interest rates to curb economic activity. This creates risk. Will the increase in interest rates cause unintended consequences — such as bank failures — which could lead to another downturn in business activity, or even recession? Or will the increase in interest rates slow down business activity just enough to allow supply chains to stabilize, inflation to moderate, and employment to remain full? The most recent economic data shows inflation moderating to 3.3% and the unemployment rate is 3.8%.
Most experts have been predicting a recession for the past several quarters. Opinion is starting to change; read more about it in the article below.
Dave Stone, MA Economics
MBA Graduate Director