The US economy is sending complex and sometimes contradictory signals right now. But in some ways, the situation is simple: Americans are making and spending more money than ever, but prices are rising even faster.
US households received $4.6 trillion in after-tax income in the second quarter, 1.6 percent more than in the first three months of the year. But consumer prices rose 1.7 percent, meaning incomes, adjusted for inflation, actually fell.
It was a similar story throughout the economy. Companies invested more in absolute dollars, but cut back once inflation is taken into account. Consumer spending may have increased faster than prices, but barely. And total economic output, adjusted for inflation, fell for the second consecutive quarter, despite accelerating without adjustment.
Those dynamics help explain why the Federal Reserve is acting so aggressively to raise interest rates and slow the economy. Inflation partly reflects that demand – for goods, services, equipment, workers – exceeds supply. By raising the cost of borrowing money, the Fed hopes to reduce demand and thus inflation.
There are signs that this is already happening. The housing market slowed significantly in the second quarter and business investment also ground to a halt; these sectors are most sensitive to rising interest rates.
But inflation is not just a result of domestic forces. The oil price has risen sharply this year after the Russian invasion of Ukraine. China’s efforts to contain the spread of the coronavirus have led to supply chain disruptions. The Fed cannot control those dynamics. Nor can it do anything to bring workers back into the labor market or otherwise help the supply side of the domestic economy.
The risk is that, in an effort to contain inflation, the Fed will curb demand so much that companies will lay off workers, unemployment will rise sharply and the economy will plunge into recession. Fed chairman Jerome H. Powell acknowledged that risk Wednesday and said the road to avoiding a recession had “limited”, though he expressed hopes that a downturn could still be avoided.
“We’re not trying to get into a recession and we don’t think it’s necessary,” he said. “We think there is a way to reduce inflation while maintaining a strong labor market.”