Federal Reserve officials are meeting this week with one major goal in mind: to cool the economy enough to slow rapid inflation.
The odds of getting that done without plunging the nation into recession are shrinking.
As the Fed prepares for an aggressive stance to curb ongoing inflation — likely to discuss a three-quarters point hike in interest rates this week — investors, consumers and economists are increasingly anticipating the economy could plunge into a downturn next year. Even researchers who think the central bank can still make a “soft landing,” where policymakers lead the economy on a more sustainable path without triggering a spike in unemployment and an outright contraction, recognize that the road to that optimistic outcome is narrower. become .
“It wasn’t clear that a soft landing was feasible,” said Michael Feroli, chief US economist at JP Morgan, who still thinks it could happen. “The difficulty has probably increased.”
The problem stems from US inflation figures, which are becoming increasingly worrying. Consumer prices rose to a pace of 8.6 percent in May, the fastest since 1981. Even after volatile food and fuel costs that the central bank can’t control much have been erased, inflation was firmer than expected last month as rents, airline tickets and hotel room rates shot up. Adding to the problem, two recent reports showed that inflation expectations are moving higher and higher.
The data suggests the Fed may need to act decisively, further slowing consumer and business spending and the labor market, to bring prices under control.
Before last week’s inflation report, central bankers were expected to raise interest rates by half a percentage point at their meeting this week and then again in July. But now the Fed is likely to discuss moving faster to try and eradicate inflationary pressures before they become a permanent feature of the economic backdrop. They could also continue to raise interest rates by more than their usual quarter increments into September or even beyond, many economists predict.
The Fed has already raised interest rates twice this year, by a quarter point in March and a half point in May. Taking more drastic action — making mortgages and business loans even more expensive, stifling business expansion plans and shrinking the labor market — would make higher unemployment and a shrinking economy more likely.
Understanding inflation and how it affects you
For months, the Fed has acknowledged that the path to slower inflation would likely be an unpleasant one. When the central bank raises Federal Funds interest rates, it filters through the economy to slow consumer and business demand, ultimately weighing down wages and prices. The way to control inflation is essentially to cause a little economic pain.
Still, top policymakers have expressed consistent optimism that, as the US labor market started off from a solid position, it may be possible to cool inflation without actually canceling out recent labor market progress. With so many vacancies per unemployed worker, the logic went, it would be possible to narrow the conditions just enough to better balance worker supply with employers’ demands.
“I think we have a good chance of a soft or soft landing,” Fed chairman Jerome H. Powell said at his press conference after the central bank meeting in May, adding that “the economy is strong and well positioned to handle a tighter monetary policy.”
But someone has to feel the pressure and cut spending for the Fed’s policies to work – and with higher and more persistent inflation, greater demand pressure will be needed to bring it into line.
JP Morgan’s Feroli said the Fed’s economic projections – to be released after this meeting for the first time since March – could show a marked slowdown in growth and a rise in the unemployment rate to illustrate that policymakers are serious about curbing of the economy and controlling prices. The unemployment rate now stands at 3.6 percent, which is below the 4 percent level that Fed officials say can sustain a healthy economy over the longer term.
If the Fed has to slow the economy drastically, it will be challenging to do so without triggering a recession. For starters, when unemployment peaks, a recession usually follows. A downturn has occurred as unemployment rose 0.5 percentage point from its recent three-month low — a relationship dubbed the Sahm Rule, according to economist Claudia Sahm.
On the other hand, interest rates are a blunt instrument and they work with a lag, and the Fed may just overdo it.
Investors fear a bad outcome. Shares plunged into a bear market on Monday — meaning they quickly fell 20 percent in value — as investors become nervous that the central bank is about to trigger a recession in its quest to tame inflation.
“People think the soft landing is a dream,” said Priya Misra, head of global rate strategy at TD Securities. “That’s the big picture.”
Frequently asked questions about inflation
What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar won’t go as far tomorrow as it did today. It is usually expressed as the annual price change for everyday goods and services such as food, furniture, clothing, transportation, and toys.
It’s not just Wall Street that’s getting darker. Consumer confidence fell to its lowest level ever recorded in preliminary data from the University of Michigan survey, and expectations of higher unemployment have risen in a New York Fed survey.
Even if the Fed also becomes more uncertain about its chances of gently slowing the economy, Mr Powell may not say so. A prediction that the economy will face difficult times from a top central bank official could become a self-fulfilling prophecy, shattering already fragile confidence.
“They went from soft to soft – I don’t think there’s another term they could use to say ‘not a complete disaster,'” Ms. Misra said. “I think the markets are calling their bluff, that they won’t be able to achieve it.”
A recession would cause problems for the White House. President Biden has certainly emphasized that the Fed is independent and that it will respect its ability to do what it sees as necessary to bring inflation under control, even as its approval ratings are cracking and the economy is headed for a potentially difficult transition period.
“The Federal Reserve has the primary responsibility to control inflation,” Mr Biden wrote in a recent opinion column. He added that “Former presidents have tried to improperly influence its decisions during periods of high inflation. I won’t do this.”
Still, some have argued that the central bank shouldn’t be the only game in town when it comes to controlling inflation, given the pain its policies cause. Skanda Amarnath, executive director of the employment advocacy group Employ America, argued that the White House should take more aggressive steps to improve gas supplies, such as trying to offset inflationary pressures.
Trying to stifle it by suppressing demand — which the Fed can do — would cost too much, he argued.
“If you are going to rely exclusively on the Fed to solve this problem, the outlook is not good,” he said.
But most mainstream economists see the Fed as the primary solution to inflation, just as it was when Paul Volcker led it in the 1980s. He raised interest rates to punishing, recession-inducing levels to drive down prices that had surged in the 1970s. That is why many expect a major move on Wednesday.
A three-quarter point move “would underscore their commitment to avoiding the mistakes of the 1970s,” said Diane Swonk, chief economist at Grant Thornton. “They’re now trying to cut inflation and keep it low in a more inflation-prone world.”