Fed bets on a ‘soft landing’, but recession risk looms

Jerome H. Powell, chairman of the Federal Reserve, emphasized this week that the central bank he heads could succeed in its quest to rein in rapid inflation without causing unemployment to rise or trigger a recession. But he also acknowledged that such a benign outcome is not certain.

“The historical record provides some reason for optimism,” Powell said.

That “some” is worth noting: While there may be hope, there’s also cause for concern, given the Fed’s track record when it’s in inflation-fighting mode.

On occasion, the Federal Reserve has managed to raise interest rates to cool demand and dampen inflation without significantly damaging the economy: Powell highlighted examples in 1965, 1984, and 1994. But those cases came amid much lower inflation. and without the ongoing shocks of a global pandemic and a war in Ukraine.

The part that Fed officials avoid saying out loud is that the central bank’s tools work by slowing the economy, and weakening growth always carries the risk of overreacting. And while the Fed ushered in its first rate hike this month, some economists, and at least one Fed official, think the central bank was too slow to start taking its foot off the gas. Some warn that the delay increases the chance that you will have to overcorrect as a result.

The Fed has triggered recessions with rate hikes before: It happened in the early 1980s, when Paul Volcker raised rates in a campaign to bring down inflation very quickly and caused unemployment to skyrocket painfully in the process.

“There is no guarantee that there will be a recession, but inflation is high, and if you really want to bring it down quickly, it has to go high,” said Roberto Perli, head of global policy at Piper Sandler. , an investment bank and former Fed economist. “The economy doesn’t like that. I think the risk is substantial.”

Not surprisingly, it can be difficult to cool inflation while maintaining an economic expansion. Higher borrowing costs filter through the economy by slowing the housing market, discouraging big purchases and prompting businesses to scale back expansion plans and hire fewer workers. That broad pullback weakens the labor market and slows wage growth, helping inflation moderate. But the chain reaction develops gradually, and its results can only be seen with a delay, so it’s easy to hit the brakes too hard.

“No one expects a soft landing to be easy in the current environment; very few things are straightforward in the current context,” Powell acknowledged during his remarks this week, adding, “My colleagues and I will do our best to succeed in this challenging task.”

Six of the Fed’s eight rate-hike cycles since the early 1980s have ended in recession, though some of them were caused by external shocks, such as the pandemic, and others by asset bubble implosions. , including the 2007 housing crisis and the collapse of the Internet. actions in the early 2000s.

Fed officials hope the current strong economy will help them avoid a hard landing. They point to the fact that labor markets are booming and consumer demand is strong, so raising rates and curbing voracious buying could help supply catch up and cool the economy without freezing it. Powell has argued that with so many job openings per unemployed worker, the Fed could slow down the labor market a bit without driving up the unemployment rate.

Loretta J. Mester, president of the Federal Reserve Bank of Cleveland, said the Fed was not at a point where it had to decide between fighting inflation or crushing growth.

“Given where the economy is now and where the risks are, in my opinion the biggest economic challenge is inflation,” Mester told reporters on a call Wednesday. “I don’t see it as compensation at this point.”

James Bullard, president of the Federal Reserve Bank of St. Louis, said in an interview that he thought the fact that the central bank had credibility as an inflation fighter — and raised rates to defend that credibility — might allow it to tighten the politics. in a way that allowed demand to moderate without causing major economic disruption.

In the 1980s, when Paul Volcker was Fed chairman, the central bank had to convince the world that it was prepared to rein in inflation after more than a decade of rapid price increases.

“Do whatever it takes, I guess that’s the mantra of the day; I think inflation is our main concern,” Bullard said. “However, I don’t think it’s a Volcker-like situation.”

Consumer and market expectations of short-term inflation have soared over the past year, as inflation has hit a maximum of 40 years and continued to accelerate, but longer-term price growth expectations have risen only slightly.

If consumers and businesses were anticipating rapid price increases year after year, that would be a worrying sign. Such expectations could become self-fulfilling if companies felt comfortable raising prices and consumers accepted those higher costs but demanded larger paychecks to cover their rising expenses.

But after a year of rapid inflation, there is no guarantee that long-term inflation expectations will remain in check. Keeping them in check is a big part of why the Fed is moving now, even as the war in Ukraine fuels uncertainty. The central bank raised rates for a quarter point this month and projected a series of interest rate hikes to come.

While officials would generally look beyond a temporary spike in oil prices, such as the one that has sparked the conflict, concerns about expectations mean they don’t have that luxury this time.

“The risk is rising that a prolonged period of high inflation could push long-term expectations uncomfortably higher,” Powell said this week.

Powell noted that the Fed could raise interest rates by half a percentage point in May and imminently start reducing its balance of bond holdings, policies that would remove aid from the US economy much faster than in the last economic expansion.

Some officials, including Mr Bullard, have urged swift action, arguing that monetary policy is still in an emergency situation and not in keeping with a very strong economy.

But investors believe the Fed will need to change course after a series of rapid rate hikes. Market prices suggest, and some researchers believe, that the Fed will raise rates markedly this year and early next, only to reverse some of those moves as the economy slows markedly.

“Our base case scenario has the Fed backtracking fast enough to avoid a full-blown recession,” Krishna Guha, head of global policy at Evercore ISI, wrote in a recent analysis. “But the probability of achieving this is not particularly high.”

So why would the Fed put the economy at risk? Neil Shearing, the group’s chief economist at Capital Economics, wrote that the central bank was following the “stitch in time saves nine” approach to monetary policy.

Raising interest rates now to reduce inflation gives the central bank a chance to stabilize the economy without having to enact even more painful policy later. If the Fed stalls and higher inflation becomes a more enduring feature of the economy, it will be even harder to crack down.

“Delaying rate hikes due to fears about spillover economic effects from the war in Ukraine would risk inflation becoming more entrenched,” Shearing wrote in a note to clients. “Which means that ultimately more policy tightening is needed to get it out of the system and make a recession at some point in the future even more likely.”

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