Paul Krugman: The economy Is looking pre-recessionary

As an American of a certain age, I know quite a few people who’ve been warned by their doctors that they’re prediabetic. That is, their blood sugar is sufficiently elevated to put them at risk of Type 2 diabetes, even though they aren’t yet showing any symptoms. The good news is that they can greatly reduce that risk by losing weight, improving their diet and getting more exercise. But they need to take action quickly to avoid serious health problems.

No, this isn’t a medical advice column. But I found myself thinking about medical analogies when looking at recent economic data. The United States probably (probably) hasn’t entered a recession yet. But the economy is definitely looking pre-recessionary. And policymakers – right now basically meaning the Federal Reserve – need to move quickly to head off the risks of serious economic deterioration.

It’s clear that the Fed made a mistake by not cutting rates last week; indeed, it probably should have begun cutting months ago. Unfortunately, we can’t turn back the clock. But the Fed’s open market committee, which sets short-term interest rates, can and should make a substantial cut – probably half a percentage point, rather than its usual quarter-point – at its next meeting, scheduled for mid-September.

And we can only hope that the recent plunge in long-term interest rates, which reflects expectations of future Fed cuts, will be enough to avert a gratuitous economic slump.

Why do I say that the economy looks pre-recessionary? The most important factor is the unemployment rate, which has been gradually trending up over the past few months. Friday’s employment report triggered the Sahm rule, which says that a sufficiently large rise in the unemployment rate is a strong indication that a recession has started. Many economists, including Claudia Sahm, who devised the rule, believe that for a variety of technical reasons things may not be as dire as they look. But even so, the situation is worrisome.

It’s not just the official data. Private surveys and general buzz also point to a softening economy. The appraisal of the labor market by consumers surveyed by the Conference Board has deteriorated, Amazon has warned that consumers seem cautious, and so on. None of this screams recession, but it does point to a rising risk of a near-future recession.

Am I 100% sure that we’ll have a recession unless the Fed moves quickly to cut rates? Of course not – nothing is certain in economics, or in life more generally. But policymakers who wait for perfect certainty before acting will always move too late.

So how did we get to this point? The Fed increased interest rates a lot in response to the 2021-22 surge in inflation. I didn’t oppose that move; I don’t think the Fed had a choice, given the perceived risk that inflation might become entrenched in the economy the way it did in the 1970s.

By the second half of 2023, however, it was clear that fears of a return to that ’70s show were misplaced; inflation was coming down steadily without the years of high unemployment some economists wrongly claimed would be necessary.

But the Fed didn’t respond to falling inflation by cutting interest rates, seemingly unwilling to act until it was sure inflation was back to target. (Another example of how waiting for perfect certainty guarantees that you’ll move too late.) To some extent, the Fed may have been the victim of a statistical head-fake: Official numbers showed rising monthly inflation in early 2024, but as I wrote at the time, this looked more like noise in the data rather than anything that really happened.

Beyond that, however, it’s hard to escape the sense that the Fed has to some extent been paralyzed by inflation PTSD. Having faced harsh criticism for moving too slowly to raise rates when inflation began rising a few years ago, it may have compensated by failing to cut rates when inflation began to fall. For a long time, our economy held up remarkably well despite very high interest rates; now the cracks are starting to show.

What’s especially galling about the current situation is that we may be about to snatch defeat from the jaws of victory. As of right now, America has basically achieved what many economists had considered impossible: a soft landing, in which we managed to get inflation way down without high unemployment. But we are increasingly at risk of experiencing a lot of unnecessary pain simply because the pilot waited too long to pull up the plane’s nose.

One more thing: If the Fed cuts rates in September, it will probably face a firestorm of criticism from Republicans accusing it of trying to help Kamala Harris defeat Donald Trump in the presidential election. And yes, a rate cut would probably help Democrats, largely because it would help drive home how successful America has been in bringing inflation under control.

But politics shouldn’t, and I hope won’t, affect the Fed’s decision. For the fact is that the economic case for major rate cuts is overwhelming; the Fed would be acting politically if it didn’t respond to that economic case simply because the election is looming.

This article originally appeared in The New York Times.