GDP Shrinks: The Good and the Bad

The advance estimate for 2022’s first quarter gross domestic product (GDP) is in, and the news is not good. Adjusting for inflation, GDP shrank 0.4 percent from the previous quarter. If GDP stays on its current path for the entire year, the economy would shrink by 1.4 percent. A revised estimate will come out on May 26, but likely won’t be much different. Let’s unpack some of what today’s news means.

The big news is that the economy is at a high risk of recession. The standard definition of a recession is when GDP shrinks for at least two quarters in a row. We may even be in one now, though we won’t know until next quarter’s results arrive in July.

The other big news is that the Fed’s inflation-fighting job just got more difficult. The reason inflation is high right now is because the money supply is growing faster than GDP. If they were growing perfectly in sync, inflation would be near zero. Right now they are mismatched because the Fed attempted to stimulate the economy during the worst of COVID with a flood of new currency. At a technical level, inflation is easy to fix. It’s a matching game—just match money supply growth with economic output growth.

The difficult part is that tapering back inflation risks causing a recession, and we’re now officially halfway there. The Fed has been criticized for being too timid about inflation, and in my opinion rightly so. But if you’re wondering why it’s been timid, there’s your answer.

Fortunately, today’s GDP numbers aren’t on the Fed. Changes in monetary policy have a lag time that ranges from six months to as long as a year and a half, and the Fed took no action on inflation until March, when the first quarter was nearly over. But going forward, that gives the Fed an excuse for inaction. While that might prevent some short-term harm during an election year, it comes at the cost of even greater long-term harm from sustained high inflation.

Fed Chair Jerome Powell recently indicated that the Fed will take more aggressive steps starting at its next Board of Governors meeting in May. But with today’s news, will he keep that promise?

That’s the bad news. But there are some good points. The big one is that the economy is already roughly back to where it would have been if the pandemic had never happened. Last year’s breakneck growth, which peaked at 7.0 percent, was mostly catch-up growth. It caught us up to where we were going to be anyway.

The economy was mostly healthy going into the pandemic. There was no housing bubble or financial crisis. People hunkered down when COVID hit, and they opened back up when they felt it was safe. So, 2021’s rapid catch-up growth makes sense. The COVID recession wasn’t a true downturn, so much as a pause. Slower growth is a sign that things are finally getting back to normal. That’s a good thing!

That said, a shrinking economy in real terms is never a good thing. Real GDP data go back to 1947. Over the last 75 years, average annual real growth has been a little over 2 percent. If we’re caught up after the pandemic shock, we should expect growth to slow down to that 2 percent ballpark. Since the economy is shrinking, something else is going on in addition to that expected catch-up slowdown.

In sum, GDP growth was going to slow down no matter what, because the economy is now largely caught up from the COVID shock. But the fact that it actually went negative is due to a mix of factors. Inflation is the biggest one, and today’s GDP news may make them more reluctant to fix the problem they caused, especially during an election year. That is a cause for concern.

Part of the GDP reduction is from expiring COVID spending programs, and is actually good in the long run. Even most of the COVID spending bills’ supporters did not intend for them to become permanent. Russia’s invasion of Ukraine is having a small negative effect on the American economy, but is only a small part of the story, and mostly restricted to energy prices. Illiberal trade and regulatory policies are a bigger issue, which the pandemic exposed. These have mostly not been fixed, and are dragging down the economy. Congress and the Biden administration can help by liberalizing trade and regulation and allowing the Fed to do its job of reining in inflation.