What to expect if the US falls into a recession

Today’s blog post is about what we should expect if the US economy officially falls into a recession, which is looking increasingly likely.

First, a quick definition. A recession means the Gross Domestic Product is shrinking: businesses are cutting back on investment, people cut back on spending, and jobs are typically lost.

When a recession hits, the first line of defense is usually monetary policy, controlled by the Federal Reserve. The Fed would typically cut interest rates to make borrowing cheaper. Lower rates encourage households and businesses to spend and invest more, which can help lift the economy out of a downturn.

The government can also step in with fiscal policy by cutting taxes or increasing spending to boost demand and create jobs.

In a typical recession, these tools-lower interest rates and more government spending-are pretty effective.

But things get a lot trickier if we’re facing stagflation. Usually, recessions are accompanied by lower price growth because slower economic activity puts downward pressure on prices. Greater government spending, lower taxes, and lower interest rates all put upward pressure on prices. When there’s a recession and inflation falls as a result, having some inflationary pressure is fine and may even be a good thing to stabilize price growth.

But not so with stagflation, which is when the economy shrinks and inflation stays high at the same time. This creates a nasty problem: cutting rates or boosting spending might help the economy, but could make inflation even worse.

Unfortunately, recent tariffs on imported goods make the risk of stagflation higher than usual. Tariffs act like a tax on imports, raising the prices of goods like food, electronics, and industrial materials. That can push up overall inflation-even if the economy is slowing down.

In this environment, the usual playbook doesn’t work as well. If the Fed cuts rates too much, it risks fueling even higher inflation. If the government spends too much, it could drive prices up even further.

In short, if the tariffs create sizeable inflation, which is very possible, this would trap policymakers between two bad choices: Fight the recession and risk runaway inflation, or fight inflation and risk a deeper, longer recession.

The US hasn’t had serious stagflation since the 1970s, when a mix of oil price shocks and poor policy choices caused years of economic pain. But with tariffs raising costs today, the risk of stagflation is something we have to take seriously.

So what can we do to avoid stagflation? One important step would be to roll back the tariffs that are driving up prices. That would ease inflationary pressure, making it easier for the Fed and the government to focus on supporting growth without fueling higher prices.

Another tool is to target government spending carefully-focusing on investments that boost productivity over time, like infrastructure and education, rather than just pumping more money into the economy across the board.

The US eventually escaped the stagflation of the 1970s through a painful but necessary combination of tight monetary policy and structural economic reforms. So while fixing stagflation isn’t easy, it can be done with the right choices. But of course, it’s better not to create economic conditions that put us at risk of stagflation in the first place.

Originally published at https://mytwocentsandcounting.substack.com.