Most recessions start from a position where the economy is moving closer to its normal rate. Therefore, when we think of recession we think of an economy where output declines to a level below its normal rate.
In principle, a recession can start at any point in the business cycle. A recession can begin when the economy is already operating at very low potential, the recession of 1937-38 being the most famous example.
A recession can also start from a position where the economy is performing well above potential, as in the case of the recession of 1946 (and to a lesser extent 1969). In a recent blog post, George Selgin provided a really insightful analysis of the post-World War II recession (here, here And here), which in many cases did not look like a recession. For example, unemployment was low even though measured RGDP fell sharply (since wartime industries were intact.)
This period is difficult to assess because of the distortions caused by the imposition of wartime price controls and their removal after the war, which artificially increased measured RGDP during the war and artificially depressed growth after the war. It is difficult to accurately measure the value of war output not sold at market prices.
In my view, a situation where the economy returns to the trend line from the above possible position is so different from a typical recession that another term would be appropriate – say “correction”. But I can’t make rules, and I recognize that the profession as a whole refers to this situation as a “recession.”
During this type of period, you can expect the output figures to look much worse than the employment figures. This is because when the economy is overheating, companies are not able to hire as many workers as they would like. There is a shortage of workers. Why don’t companies just raise wages to eliminate the deficit? Because they are monopolists in the labor market.
When the economy slows down, companies will continue to hire workers for a period of time. You will see very weak RGDP growth numbers combined with very strong gains in employment. Sound familiar? As long as the economy simply returns to the previous trend line, unemployment need not rise to very high levels. It may look like a recession, but it won’t feel like one.
This has implications for monetary policy. Those of us in favor of level targeting argue that the economy will be more stable if the Fed promises to return its target variable (prices or better yet NGDP) to its previous trend line. The Fed accepted this argument, but only to offset demand shortfalls, not to offset demand overshoots. In 2020, they committed to undershoot inflation above normal in the future. But by the end of 2021 they refused to commit to offset an overshoot in aggregate demand with lower-than-targeted inflation in future years. That was the Fed’s original mistake. (BTW, supply-side inflation overs or undershoots need not be offset under the Fed’s dual mandate.)
Why did they make this mistake? I’m not sure, but perhaps they confused the economic correction with the garden-variety recession. They may have assumed that if the economy overheated, bringing aggregate demand back to the previous trend line would push us into recession. In a technical sense that may be true (depending on how sharp the contraction is), but it would be a recession unlike anything we’ve experienced since 1946. A kind of painless recession.
To be sure, the Fed could very easily overshoot and create a general (painful) recession, with output below trend and high unemployment. Ironically, the Fed’s refusal to engage in symmetric level targeting makes that unfortunate outcome much more likely. With level targeting, monetary policy mistakes have less severe consequences, as market expectations of future make-up policy adjustments prevent demand from going too far. In other words, the Fed is making it harder on itself with its “let’s go fast” approach to stabilizing demand.