Can the Federal Reserve tame the highest inflation in roughly 40 years without causing sharply higher unemployment?
Top officials at the US central bank say it can be done — but even they concede a recession cannot entirely be ruled out.
History suggests a so-called “soft landing” is a rare outcome.
Since the 1950s, the US economy has tipped into a recession within two years every time inflation has exceeded 4 per cent and unemployment has fallen below 5 per cent.
The dilemma confronting the Fed today is as extreme as it gets, with inflation running at multi-decade highs and unemployment at multi-decade lows.
This combination has created one of the most acute challenges for the central bank in the post-second world war era, testing the credibility of the institution and the fortitude of its leadership, helmed by Jay Powell.
Here’s how Alan Blinder, the former vice-chair of the Fed who served in the 1990s, sees it: “They are trying not to slam on the brakes too hard. Will they pull it off? I think it’s difficult and the odds are against them.”
The Fed’s primary policy tool is the
which it adjusts to influence borrowing costs for banks, businesses and households in order to achieve both parts of the central bank’s mandate: stable prices and a healthy labour market.
When the Fed wants to cool down a red-hot economy, it raises its benchmark policy rate above a
setting, a level that neither restrains nor revs up growth. If the economy is languishing, the Fed will lower the fed funds rate below neutral to boost borrowing, encourage spending and support the labour market.
To gauge inflation the Fed looks closely at changes in the core measure of the personal consumption expenditures price index — known as core PCE — which excludes volatile items like food and energy prices.
Over time, it seeks to achieve inflation that averages
While core measures are good at predicting future inflation, the Fed also keeps close tabs on broader metrics like the consumer price index, which measures price changes paid by consumers for everyday goods and services.
This metric is important because it influences people’s expectations about future inflation.
The Fed also seeks to foster an environment of low unemployment, where everyone who is willing and able to work has a job.
Defined as “maximum employment,” the second goal of the Fed’s dual mandate is to maintain the highest amount of employment that can be sustained without creating excessive inflation.
Officials pay close attention to the non-accelerating inflation rate of unemployment NAIRU, which is an estimate of the lowest level of unemployment before unwanted price pressures start to mount.
Not all tightening cycles have resulted in a
But the Fed’s track record is spotty at best. Nearly every time the central bank has raised interest rates above neutral to rein in inflation, a recession has followed soon after.
What makes the current situation all the more challenging is the enormity of the inflation problem. At no point in the past four decades has the Fed’s preferred inflation gauge run so far above its 2 per cent target and unemployment hovered so far below what is considered a sustainable rate, analysis from Deutsche Bank shows.
After first moving cautiously to scale back the massive amount of policy support being pumped into the economy and financial markets, the central bank was forced to abruptly pivot. It is now tightening monetary policy at the most aggressive pace since 1981.
In just four months, the Fed has raised the fed funds rate from near-zero to a new target range of 2.25 per cent to 2.50 per cent. To get there, officials implemented supersized rate rises, including two consecutive 0.75 percentage point increases. Typically, the Fed adjusts its benchmark policy rate in quarter-point intervals.
Interest rates are expected to continue rising, with another 0.75 percentage point increase under consideration for September’s policy meeting. Rates will need to increase to a level that actively restrains the economy, Fed officials say, but just how restrictive they need to be and for how long remain open questions.
The Fed’s goal is to avoid a repeat of the severe economic shock it was forced to deliver in the 1980s in order to get a handle on inflation after a series of policy mistakes in the 1970s.
Rather than the “hard” landing that defined that period, the Fed wants to emulate the quintessential soft landing of the early 1990s, when it successfully addressed budding inflationary concerns without causing undue economic pain.
The 1970s is a cautionary tale for the Fed and underscores the risks of “stop-go” monetary policy in which the central bank flip-flopped between raising rates to stem inflation and cutting rates to shore up growth. In the process, it failed to vanquish high prices and inflation became deeply embedded into the psyches of Americans.
This emblematic episode, which can trace its roots back to the late 1960s, became known as the period of the “Great Inflation”. It gathered momentum in the early part of the decade after Arthur Burns took over as Fed chair in January 1970 amid a recession and unnerving geopolitical shocks.
Between 1972 and 1974, the Fed raised interest rates as growth rebounded.
It then cut rates in 1975, when the economy had tipped into a recession . . .
. . . but before inflation had moderated sufficiently.
And though inflation fell from its peak, it settled at a relatively high level.
The oil crisis in 1979, which led to nationwide gasoline shortages and soaring prices, ignited yet another round of inflationary pressure and revealed in stark detail the magnitude of the Fed’s policy errors.
Paul Volcker sought to change that when he took over as chair in August 1979. By then, inflation had climbed to 12 per cent and was poised to rise further.
After two months in the job, Volcker fundamentally changed the way the Fed set monetary policy, targeting the supply of money in the financial system rather than interest rates explicitly. The fed funds rate quickly neared 14 per cent.
Over the course of a couple of months, rates skyrocketed further, plunging the economy into a recession.
Around that time, Volcker said: “Failure to carry through now in the fight on inflation will only make any subsequent effort more difficult, at much greater risk to the economy.”
By the end of 1982, the economy had collapsed and another recession ensued. Unemployment rose sharply as millions of people lost jobs and debt crises rippled across emerging markets.
Inflation, meanwhile, fell back to 5 per cent.
The Fed was able to ease monetary policy soon after, providing much-needed relief to the labour market.
There are big differences between the current situation and the circumstances of the 1970s. The Fed has far more credibility now than in the past and its commitment to keeping prices stable is more deeply ingrained.
However, the tumult of that period — and the economic downturn that followed — offers up important lessons for the central bank today: a failure to tighten monetary policy enough now could allow inflation to become entrenched and ultimately require more drastic action later.
“It was at least a dozen years of just utter abdication of responsibility and a ratcheting up of inflation,” says Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics and a former Fed staffer.
“By the time Paul Volcker came in, everyone expected that inflation was just going to continue indefinitely,” he adds. “That is just not the case now. Everyone is willing to give the Fed the benefit of the doubt.”
Powell recently signalled that the central bank had internalised the lessons of the 1970s, saying: “If you fail to deal with [inflation] in the near term, it only raises the cost of dealing with it later.”
Still, Fed officials remain steadfast that there is a path to bring down inflation without causing a recession, similar to what was achieved in 1994.
Under the leadership of Alan Greenspan, the Fed successfully set monetary policy to stamp out inflationary fears while keeping growth intact.
The key to getting it right was pushing back on pressure to raise rates more, says Blinder, Greenspan’s second-in-command at the time. “There was tremendous hawkish sentiment, both inside the [Fed] and out in the markets that the Fed had to go higher, higher, higher, higher, and we resisted that.”
In just over 12 months, the Fed doubled interest rates to 6 per cent, cooling down an economy that had boomed in the aftermath of the 1991 recession.
Inflation, which had been running at over 3 per cent before the Fed began to raise rates, eased.
Unemployment did not spike, hovering at 5 per cent two years later. Growth slowed in 1995 but never contracted.
That is the outcome the Fed is trying to pull off today, but Powell has acknowledged the path to do so has “clearly narrowed . . . and may narrow further”. Rather than soft, the landing may be “softish”, he has said.
Success will partly depend on factors beyond the Fed’s control, including whether the commodity price surge and supply bottlenecks largely caused by Russia’s invasion of Ukraine and China’s Covid lockdowns abate.
The odds of a “softish” landing largely depends on the resilience of the labour market. Unemployment rises even in the mildest of recessions — by roughly 2 percentage points — according to an analysis of the postwar period by Goldman Sachs.
But with unemployment hovering at a historically low level of 3.5 per cent and an urgent worker shortage that translates to nearly two vacancies for every unemployed person, today’s job market is one of the tightest on record and, in turn, among the most potentially inflationary.
To retain staff and attract new hires, employers have boosted pay and improved benefits — sowing fears of a “wage-price spiral” whereby companies are forced to charge more for their products and services to cover higher costs, leading workers to demand even higher pay to keep pace with rising prices.
Fed officials argue that their efforts to cool labour demand will result in employers shrinking the number of job openings as opposed to slashing positions altogether. As of June, most officials projected unemployment to rise to 4.1 per cent in 2024 from its current level of 3.5 per cent.
Yet many economists are sceptical that the fight against inflation will play out in such a benign manner, not least because it will require the Fed striking exactly the right balance between tightening too little and too much. Monetary policy also works with a lag, meaning it takes time for the full effects of the Fed’s actions to ripple through the economy.
For Donald Kohn, who served as the Fed’s vice-chair during the global financial crisis, the main risk is that unemployment will need to rise much more than is expected in order to take the heat off inflation.
“My suspicion is that they are going to have to take rates higher than even they thought, and certainly more than the markets thought,” he says of the Fed.
Sectors most sensitive to fluctuations in interest rates, like housing, are already starting to feel the pinch of higher borrowing costs, with sales and prices plummeting. Business investment has already started to moderate and consumers have not been as downbeat since the global financial crisis more than a decade ago. Some economists think the US is already in a recession, given that the economy has contracted for two quarters in a row.
While Fed officials appear committed to reducing inflation and maintain there are still clear signs of strength in the economy, they acknowledge the risks posed by squeezing demand excessively. That suggests they may soon recalibrate how aggressively they will raise interest rates going forward.
“The next period is going to be a really tough one,” says Bill English, a Yale professor and former director of the Fed’s division of monetary affairs. “They want to take the heat off, but not have the economy go into the ditch, and that’s tricky to manage.”
Visual storytelling team: Sam Learner, Sam Joiner and Caroline Nevitt
Sources and notes: Economic data comes from the Federal Reserve (FRED) and the US Bureau of Labor Statistics. Neutral Rate of Interest figures come from the Federal Reserve of New York, and reflect the real interest rate that is “expected to prevail when the economy is at full strength and inflation is stable”. The analysis of past tightening cycles since the 1950s referenced in the introduction was conducted by Alex Domash and Larry Summers, the former Treasury secretary. Historical sums of deviations from maximum employment and inflation come from a Deutsche Bank analysis.
Source: Economy - ft.com
