Economic Flyover with Aaron Hedlund
Aaron Hedlund is a research fellow at the St. Louis Federal Reserve Bank, a tenured professor in economics and real estate, and the former Chief Domestic Economist for the White House Council of Economic Advisers. During his tenure at the CEA, he was part of the team that helped craft and monitor the implementation of the economic rescue and recovery packages in 2020, which were designed to mitigate the economic consequences of the pandemic.
This post features a written interview with Aaron, who provided his answers in response to questions from Brent Beshore.
In 2019 you were appointed to the highly prestigious and influential Council of Economic Advisers (COA), whose job is to direct economic policy for the nation and work directly with the White House. Then COVID hit and you were at ground zero for trying to figure out the right economic policy for our nation, which significantly impacted SMBs. How would you grade your and your colleague’s performance, especially related to small business?
Hi Brent, it’s a pleasure to have the opportunity to share my thoughts with you and your readers. In terms of the 2020 economic rescue efforts, I would give us a “B” in an absolute sense – judging in a vacuum that ignores political realities – but an “A” when grading on the curve of typical fiscal policy responses. I can dive into the logic behind the actions that we took and what could have been done better, but fundamentally, I judge first and foremost by results. And despite the economy contracting at an annualized rate of 30% in the second quarter of 2020 in the face of virus fears and pandemic lockdowns, we did not witness a massive wave of bankruptcies, evictions/foreclosures, or permanent business closures either immediately or later on. This is not to say that the economy emerged unscathed, but if we were to extrapolate from historical relationships between unemployment, GDP, and various measures of financial distress from previous recessions, and in particular the 2007-09 financial crisis, we could have really been in for a world of economic pain during 2020, with long-lasting effects thereafter. Instead, GDP bounced back at a historically rapid pace in the third quarter of 2020, the unemployment rate quickly returned to low levels, balance sheets emerged largely quite strong, and inflation was low until the spring 2021 stimulus (which I view as misguided and significantly responsible for the inflation surge and labor shortages that subsequently ensued).
What are you most proud of during your time on the CEA and why?
I think the 2020 economic rescue efforts were the most successful fiscal policy response in U.S. history. That may sound like a bold claim, but it’s a mix of me thinking the response was in fact pretty good and me also thinking that past responses weren’t very good, so perhaps the bar wasn’t set very high to begin with! Despite the incredible political polarization that often hobbles progress in Washington, DC, I witnessed my colleagues jump immediately into action with a keen sense of purpose to craft creative, never-before-tried policies to prevent the economy from crashing and burning. The Paycheck Protection Program (PPP) – while far from perfect – was a particularly innovative effort.
Speaking individually, there is one specific effort with respect to small businesses that I am especially proud of. As you well know, the roll out of PPP was a bit turbulent. The national news reported on multiple instances of large companies like Shake Shack and the LA Staples Center receiving PPP loans that they seemingly did not need to stay afloat, while at the same time, some small businesses had a tough time getting loans in those first few weeks (though that quickly changed after the second round of PPP funding, with three-quarters of small businesses ultimately receiving loans).
In reaction to the bad PR, Treasury Secretary Mnuchin began rapidly issuing public guidance documents that added conditions to PPP loans after the fact when businesses had already applied and were receiving funds. These ad hoc conditions were nowhere to be found in the CARES Act that created the PPP or in the loan application documents, and many small businesses understandably perceived the flurry of new guidance documents as a source of legal uncertainty that made them highly reluctant to apply for loans or use the funds. However one might think the PPP should have been designed, the reality is that the law was created to be broad to encourage as many businesses as possible to apply for funds and keep workers on the payrolls instead of resorting to layoffs. After all, the main criteria that businesses had to stipulate to in their loan application, “Current economic uncertainty makes this loan request necessary to support the ongoing operations of the Applicant,” arguably encompassed the vast majority of businesses in spring 2020 when nobody knew how events were going to play out..
When it became clear to me that the Treasury’s guidance was creating reluctance among business owners to apply for loans – thus undermining efforts to keep as many workers as possible on the payrolls – I jumped into action reaching out to Cabinet-level officials and laying out the problem that was rapidly unfolding because of our own efforts in reacting to bad PR. After multiple high-level meetings and calls, the Treasury eventually issued a safe harbor for all but the very largest PPP loans that basically presumed that small businesses were acting in good faith in light of the broad loan application language. I think this U-turn could very well have saved the program from unraveling. While this action was just “behind the scenes,” I was proud I could raise the alarm and meaningfully change the implementation of such a critical program.
No effort is perfect. What do you wish you could go back and do differently?
The biggest shortcoming in my mind was not rolling out a much more aggressive package of policies in fall 2020 aimed at pivoting the economy toward rapid re-hiring and a return to normal. The CEA chair and I developed an idea for a reformed and much bolder version of an employee retention tax credit (ERTC) that, despite using the same the label, would have looked quite different from the actual ERTC that existed at the time and instead resembled a generous hiring subsidy for companies expanding their total payroll count beyond spring 2020 levels. In addition, I think it would have made sense to institute a temporary payroll tax reduction and some form of re-employment bonuses for workers to get them off the sidelines faster. Ultimately, electoral politics caused Congress to lose any interest in further bipartisan cooperation, and on top of that, the looming fall election created a temporarily heightened state of risk aversion to policy innovation in the White House itself. It became much easier to simply reauthorize existing programs than to chart a modified course.
On an individual basis, I don’t think there was much I could have done in my position to change this particular outcome, but if I were to look at my overall tenure, I definitely learned a lot about my strengths and where I can improve as a leader. In my life as an academic, most of my work is either individual or in conjunction with co-authors, which mostly entails occasional meetings that result in a set of to-do items that we go off and execute independently. By contrast, in the White House, I was gradually given greater responsibilities to spearhead projects that involved teams that I supervised. It took practice to be willing to let go of being a perfectionist and do too much myself and instead delegate, empower, and trust those under me. I got better at this with time, but like everybody, I am still a work in progress.
Pre-COVID, there was a widely held consensus that inflation was a thing of the past, which obviously now looks laughable. To go back, the argument was that technology is inherently deflationary and central banks around the world were even charging negative interest rates. What happened that shifted us from a low-inflation and even deflationary environment to what we’re experiencing now?
It’s truly astounding how quickly things can change. In the aftermath of the high inflation of the late 1970s and early 1980s, there were a solid two decades of impactful monetary policy research on how to prevent future similar episodes, and I think we learned meaningful lessons. Perhaps the number one lesson is that the Federal Reserve’s top mandate must always be keeping inflation low and stable and not blinking even if unemployment starts to rise. I would go so far as to argue that the 1970s/80s experience created a sense of “institutional PTSD” in the Fed that continues to shape its thinking. While technological innovation and other factors likely have contributed to low, stable inflation over the past few decades, I believe the Fed’s hard-won credibility with markets about its commitment to always being vigilant against high inflation has been the most critical factor given considerable evidence that inflation expectations can become self-fulfilling if not nipped in the bud before they become “unanchored” (to use Fed speak).
In some ways, we have been a victim of our own inflation-fighting success, with interest waning among economists in researching the drivers of high inflation (with some notable exceptions, especially for economists studying Latin America) as they pivot toward researching other topics or even toward studying the dangers of too low inflation. Moreover, the belief that the Fed could always handle things on its own has arguably contributed to a sense of complacency within the elected branches of government about the need for discipline on the spending side.
This, I believe, is where the key lies for understanding the inflation predicament over the past two years. Prior to passage of the American Rescue Plan Act (ARPA) – President Biden’s $2 trillion stimulus package – in spring 2021, U.S. GDP was nearly back on track, unemployment was in the 6% range and falling (having peaked at nearly 15% in spring 2020), and inflation was still below 2%. In my view – and not just mine, but also people like former Clinton Treasury Secretary and Obama National Economic Council Director Larry Summers – there was absolutely no need for “stimulus” in spring 2021. What we needed was a return to a semblance of fiscal normalcy and getting people back to work. Instead, the economy got a huge injection of deficit-financed money that artificially boosted demand accompanied by provisions that made it more lucrative for people to continue staying on the sidelines of the labor market, thus constricting supply. More demand and less supply is a classic recipe for higher prices. And even though many of those policies have lapsed, the genie was let out of the bottle, and people are still sitting on a mountain of government-provided liquidity that, in my view, has been slowing progress both in bringing down inflation and alleviating labor shortages (which are connected phenomena).
If you’re under 45, there’s zero muscle memory of how to operate with high inflation. How should SMB owners and operators think about inflation?
Arguably the biggest practical lesson from 2021 and 2022 is that the inflation dragon has not been permanently slain, and thus SMB owners and operators should have contingency plans ready to go for the future in case inflation emerges again. Economic forecasting is often a dicey affair, but now is the time to consider a wider range of trajectories for interest rates and growth not just over the next couple of years but going into the future. For nearly two decades, people have become accustomed to extremely low interest rates and, until now, stable inflation. I have faith that inflation can be brought back down, but we can no longer count on a world where mortgage rates are persistently below 4 percent (let alone 3 percent) or where other borrowing costs are rock bottom. As we have seen, fiscal pressures from large government imbalances can put upward pressure on inflation and interest rates, and there is nothing immediately on the horizon to suggest that the government’s fiscal picture is going to notably improve. Layer on top of that the impending tidal wave of baby boomer retirements, and we are looking at a potentially prolonged period of labor force availability challenges unless something happens to either bring domestic workers back off the sidelines or address immigration in a sensible way (with nobody agreeing on what “sensible” even means).
What counterintuitive or non-obvious things should SMBs have on their radar related to inflation and what steps would you recommend they take to protect their business?
First of all, I would point out that SMB owners and operators may want to pay at least as much attention to the Producer Price Index (PPI) as they do the Consumer Price Index (CPI), which often gets more press. I won’t get into all the technical differences here (here is some enticing bedtime reading), but one thing to note is that the PPI measures the prices received by domestic producers, whereas the CPI measures the prices paid by domestic consumers. One implication is that the CPI includes some items that may not be as directly relevant to SMB owners and operators (like owner-equivalent rent), and the CPI also includes imports. If an SMB’s primary competitors are just domestic producers, the CPI may therefore be less informative in serving as a benchmark for pricing behavior. For small businesses whose primary customer base is other businesses, rather than the end consumer, the PPI is also more informative because it looks at pricing pressures for intermediate goods.
This is not to say that the CPI is unimportant, because the CPI gives insight into the pressures consumers are facing and, in turn, how robust their spending activity is likely to be going forward. This brings me to my second point, which is that SMB owners and operators would be wise to pay attention both to price inflation (as measured either by the CPI or PPI) as well as wage inflation – which is reported in the monthly jobs reports as average hourly or weekly earnings – to have a good barometer for the wage pressure they are likely to face in hiring and the purchasing power of the American consumer.
In terms of tangible actions or planning SMB owners and operators can take, I would be thinking both about the pricing and compensation sides of the equation. If there is any “upside” to inflation, it creates some flexibility by making some uncomfortable decisions less uncomfortable. For example, if a business has felt cost pressures for some time (preceding the inflation spike of 2021 and 2022) but was reluctant to raise prices fearing a backlash for their customers, the current inflationary episode provides good “cover” for them to reset prices to a more suitable level. In addition, if SMBs have some workers whose pay was not matched with commensurate productivity, but they didn’t want to actually lay off those workers or overtly cut pay, then inflation is a way to let pay erode “naturally” for such workers, and in some cases those workers may choose to leave of their own accord to find a different job that pays them more.
I would never argue that inflation is good on the whole, however. High inflation tends to mean not just fast increases in the overall price level but also higher price volatility and unpredictable swings in relative prices between goods. This makes it all the more important for SMB owners and operators to know not just their specific market, but also the markets for goods that can serve either as complements or substitutes and be aware of what is happening to prices in those markets. Going forward, I would also encourage SMB owners and operators to bake in contingencies and flexibilities in their price and wage contracts should inflation take another unpredictable turn in the future. Hopefully this won’t be the case, but hope is not a plan.
I know you don’t have a crystal ball, but from my experience with you you’re usually pretty close to correct on where things are headed economically. So I’ll ask the obvious question…How long is high inflation going to endure? What does that mean for continued Fed interventions? How long should SMB operators plan to have an elevated cost of capital?
The good news is that I am reasonably confident (and I recognize I may very well regret this if proven wrong) that inflation is going to fall markedly in 2023. Unlike the Federal Reserve’s wild underestimates for inflation in 2022, I think its projections that inflation could end 2023 in the mid-3s (compared to being over 7 now) is quite plausible, with inflation falling somewhere into the 2% range in 2024. I believe we’ll see a considerable drop in the headline CPI number during the first half of the year starting around February, though I’m less certain about how the second half of the year plays out. Overall, SMB owners and operators should face a notable reprieve from the whiplash in inflation and interest rates they’ve endured over the past couple of years. That said, we may get a mild recession in the process. Regardless, with the Federal Reserve now acting aggressively after being late to the game initially, and with a divided federal government putting a halt to any major spending proposals, the headwinds from inflation should ease up a bit in 2023.
Let’s talk about the broader economy. For us lay people, can you explain why rising interest rates negatively affect economic growth?
Rising interest rates put a damper on short-run growth – which I recognize is what gets all the press – but they’re actually not the pivotal factor for long-run economic growth prospects. As for the short run, higher interest rates mean more expensive borrowing, which hurts the spending appetite of consumers and also raises the cost of capital for businesses. Thus, we end up with less consumer spending and lower investment than we would otherwise have with lower interest rates. In addition to the direct effect of interest rates on consumer spending, it also reverberates through revaluation of assets like real estate, where stagnating or declining house prices (as I expect to be the case, though nothing like from 2007-2011) cause people to cut back on spending. Over the long haul, productivity growth is the key driver of economic growth, which opens up a whole separate conversation about things we should be doing on that front to spur innovation and investment in all forms of capital, including human capital.
It feels like we’re either already in the “R word,” or are headed there quickly. How should operators think about enduring a recession and for how long? What can past recessions tell us about our present circumstances?
The analogy I use is that the U.S. economy right now is a plane flying through turbulence. In one moment, the plane dips and you feel your stomach drop, and in the next moment the plane bounces up a bit and your head feels weird (at least mine does). GDP contracted during the first two quarters of 2022 but then posted a respectable growth number in the third quarter, though this was largely driven by a temporary blip related to higher exports and lower imports that there is little reason to believe will persist. I’d say we’re 50-50 on GDP growth in 2023 going negative again (i.e. recession territory), but even the best reasonable case scenario in my view is growth that is just treading water.
Eventually, we’ll be through this part of the cycle and things will start looking up. What leading indicators would you be watching for an “economic spring?”
I am confident that we would not even be talking about a recession had inflation not reared its head over the past year and a half. Thus, the first sign of a new dawn will be inflation re-entering the orbit of the Fed’s 2% target. The next thing I’m looking for is a rebound in productivity. The outright declines in the first half of 2022 were quite alarming, and third quarter productivity was barely above zero, which means we’re still less productive as an economy (less output per labor hour) than we were a year ago. Some of the problem may be hiccups that businesses are facing with remote work and hybrid schedules, but some of the problem has deeper roots related to a generalized ossification of too many corners of the economy. For example, the number of jobs subject to occupational licensing regulations is much higher than it used to be, and constraints on housing supply make it expensive for workers to live where they can be the most productive. Whether policymakers pursue any useful remedies remains to be seen, but I do fundamentally believe in the private sector’s ability to innovate, and as soon as we see a consistent uptick in productivity, I will breathe a sigh of relief.
When those indicators start turning from red to yellow to green, what actions should operators take?
Even after inflation normalizes, I anticipate that the competition for talent is going to remain fierce for the foreseeable future. The baby boomers are retiring en masse, and many prime-age workers (especially men) remain on the sidelines. Thus, even more than is already the case, SMB owners and operators should view their workers as closer to a capital asset that needs to be maintained and invested in over the long haul, given the increased difficulty of finding and replacing workers. Thus, owners and operators should start thinking now about their pipeline at every stage of production and every stage of management, ensuring that they have in place a good ecosystem for training and mentorship and clear career pathways for employee retention. To be honest, I don’t think SMB owners and operators need to wait for a light to turn green – they may as well start now.
Looking over the next few years, arguably the worst source of uncertainty isn’t macroeconomic conditions (which are unlikely to be great, but I don’t see a deep recession around the corner either), but rather the policy environment. Several provisions of the 2017 Tax Cuts and Jobs Act are set to expire soon, such as full expensing. I, personally, would view that as a mistake. If Congress decides to extend those provisions, that would definitely represent a green light for SMB owners and operators to go ahead and invest in projects that make sense for them.
I’m an SMB operator whose business is doing okay, but not great. I see big opportunity, but also don’t want to overextend myself with all this uncertainty and with a high cost of capital. What advice would you give me on how aggressive to be?
Coming from someone who studies the economic data instead of lives it on a daily basis, I am probably more risk averse than many of your SMB owner and operator readers (though I like to think I’m more willing to be bold and “outside the box” than many). Thus, the two phrases I would put out there are “contingency planning” and “stress testing.” When setting aside liquidity buffers or evaluating investment options, don’t just construct discounted cash flows and other other key metrics using a single scenario for the interest rate and inflation environment. If an SMB owner or operator finds an investment that looks great if the macroeconomic environment evolves one way but turns disastrous or even threatens their company’s viability if indicators go the other direction, that’s probably a signal that they’re being too aggressive or need to think seriously about hedges. Of course, for this advice to be useful in a practical way, one has to take somewhat of a stand on the variance of scenarios to consider. I wish I could give ironclad guidance here – which I can’t – but I’ll reiterate what I mentioned earlier, which is that I think the likelihood of a deep recession is low. The likelihood that inflation remains as high as it has been is also low. I think the 25%-75% range for economic conditions over the next couple of years is that inflation is somewhere between 2% and 5%, with growth somewhere between -1.5% and +1.5%, and unemployment somewhere between 3.5% and 5.5% (I recognize these predictions will be my famous last words). Plan accordingly!
