The US economy is sending complex and sometimes conflicting signals at the moment. But the situation is simple in some ways: Americans are earning and spending more money than ever before, but prices are rising faster.
American households earned $4.6 trillion in after-tax income in the second quarter, up 1.6 percent from the first three months of the year. But consumer prices rose by 1.7 percent, which means income, adjusted for inflation, has actually fallen.
It was a similar story across the economy. Businesses invested more in absolute dollars, but cut back once inflation was taken into account. Consumer spending rose faster than prices, but just barely. Total economic output, adjusted for inflation, declined for the second consecutive quarter, although it accelerated unadjusted.
This dynamic helps explain why the Fed has moved aggressively to raise interest rates and slow the economy. Inflation reflects, in part, that demand — for goods, services, equipment, and workers — is outstripping supply. By raising the cost of borrowing money, the Fed hopes to reduce demand and with it inflation.
There are indications that this is already happening. The housing market slowed significantly in the second quarter, and business investment also stalled; These sectors are among the most sensitive to rising interest rates.
But inflation is not just a consequence of domestic forces. Oil prices rose sharply this year after the Russian invasion of Ukraine. China’s efforts to contain the spread of the coronavirus have added to supply chain disruptions. The Federal Reserve cannot control these dynamics. Nor can it do anything to bring workers back into the labor market or help the supply side of the local economy.
The danger is that in an effort to control inflation, the Fed will slow demand so much that companies start laying off workers, unemployment rises sharply and the economy falls into recession. Jerome H. Powell, Fed Chairman, took that risk on Wednesday, saying the path to avoiding a recession was “narrow” even as he hoped deflation could be avoided.
“We’re not trying to see a recession and we don’t think we have to,” he said. “We believe there is a way for us to be able to bring down inflation while maintaining a strong labor market.”