Federal Reserve’s Powell: Inflation is Job 1, despite recession risk

From stocks to housing to retail, indicators of a slowing US economy are flashing red. And it’s not just the United States: the International Monetary Fund recently lowered its forecast for global economic growth.

This may sound like bad news. But for the Federal Reserve, a slowdown could be just what is needed to get inflation under control and reset expectations about where prices are headed after a torrid period of fiscal and monetary expansion.

Why we wrote this

Indicators point to a slowing economy, but inflation, high for 40 years, remains untamed. This creates a delicate balance for policy makers between vigilance in the fight against inflation and the risk of destabilizing the economy.

The risk is that the Fed’s inflation-fighting cure of raising interest rates proves too strong and sooner or later a recession will follow. This risk, which President Biden acknowledged on Monday while insisting that a recession was not inevitable, is what makes central banking as much an art as a science. For Fed policymakers, it’s about finding the right balance between support and moderation, so the economy can thrive but not overheat.

“We don’t quite understand the dynamics of the recession,” says Louise Sheiner, policy director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution. This makes it difficult to assess “exactly how much the Fed needs to move to lower inflation without [triggering] a bad dynamic where consumers become pessimistic and companies become pessimistic.

From stocks to housing to retail, indicators of a slowing US economy are flashing red. Consumer sentiment in a very popular monthly survey by the University of Michigan fell in April to its lowest level in a decade. And it’s not just the United States: the International Monetary Fund recently lowered its forecast for global economic growth in 2022 to 3.6%, from an estimate of 4.4% in January.

All of this may sound like bad news. But for the Federal Reserve, a slowdown could be just what is needed to get inflation under control and reset expectations about where prices are headed after a torrid period of fiscal and monetary expansion. For its part, the Fed is trying to engineer a soft landing for the US economy by raising interest rates and signaling further hikes to come.

The risk is that the Fed’s inflation remedy proves too strong and sooner or later a recession follows. This risk, which President Biden acknowledged on Monday while insisting that a recession was not inevitable is what makes central banking as much an art as a science, despite all the data analysis involved in setting interest rates .

Why we wrote this

Indicators point to a slowing economy, but inflation, high for 40 years, remains untamed. This creates a delicate balance for policy makers between vigilance in the fight against inflation and the risk of destabilizing the economy.

For Fed policymakers, it’s about finding the right balance between support and moderation, so the economy can thrive but not overheat. And it’s especially perilous now: Even though pandemic stimulus programs, which helped inflate consumer demand, have already faded, inflation is at 40-year highs.

“We don’t quite understand the dynamics of the recession,” says Louise Sheiner, policy director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution. This makes it difficult to assess “exactly how much the Fed needs to move to lower inflation without [triggering] a bad dynamic where consumers become pessimistic and companies become pessimistic.

Critics say the Fed was behind the curve last year as inflation accelerated, fueled by stimulus spending and lower borrowing costs. Now the pendulum has swung the other way, with fears that policymakers are overtaking the fight against rising prices.

Treasury Secretary Janet Yellen warned last week that the Fed was facing “a very difficult economic situation” trying to contain inflation without pushing the United States into a recession. “I think it’s conceivable that there could be a soft landing. It takes both skill and luck,” she told reporters in Germany.

By law, the job of the Fed is to pursue — and often balance — the twin goals of price stability and full employment. Employers have raised wages to recruit workers who have more options in a tight labor market and who are also sitting on more household savings. Raising interest rates too abruptly could end this cycle just as more adults return to the labor market after the disruptions of the pandemic.

Starting salaries are advertised in the window of a Taco Bell in Sacramento, California May 9, 2022. Governor Gavin Newsom’s administration announced on May 12, 2022 that soaring inflation will trigger an automatic salary increase California minimum at $15.50 per hour next year. Inflation has outpaced wage growth nationally over the past year.

In 1994, the Fed tankless cooled inflation the economy, which continued to grow at a strong pace. But there’s no simple formula to follow, which is why soft landings are elusive, warns Joseph Gagnon, senior fellow at the Peterson Institute for International Economics.

“We have many examples of the Fed fighting inflation and causing a recession,” he says.

In 1994, inflationary pressures were essentially internal. Now the Fed must weigh the impact of external supply shocks, from oil and grain to computer chips and lumber. The shortages have pushed up the prices of these and other goods, contributing to inflation in the United States. The war in Ukraine and repeated pandemic lockdowns in China have only added to the disruption in recent months.

The problem for central bankers is that while rising domestic interest rates may dampen demand for imported goods, it does not necessarily unblock supply chains. And regardless of where the Fed sets rates, the global supply chain will always have to find its own workarounds.

In March, the Fed raised its benchmark interest rate by a quarter of a percentage point, after two years of near zero. Earlier this month, it raised it again by half a point to a range of 0.75-1.00%.

Fed Chairman Jerome Powell signaled that two more half-point hikes are expected to follow in June and July. Asked on May 4 whether a tightening could harm the economic recovery, Powell stressed long-term price stability. “There can be some pain associated with returning to ‘2% inflation,’ he said, adding that “the big pain over time is not facing inflation and allowing it to take root”. (The Fed’s inflation target is 2%).

Polls show that inflation is a major concern for American voters as they prepare for the midterm elections. Low-income consumers are disproportionately affected by rising gas and grocery prices. But the sentiment that inflation is bad and the government is to blame is shared by all economic classes and has forced the Biden administration to back down as the White House has limited options to fight inflation.

Some left-wing economists claim that, with wage growth being lower than the rate of inflation, the Fed should consider letting inflation stay above its target for a longer period in order to sustain the recovery. From this perspective, looser monetary policy that helps raise wages at the bottom of the income distribution may be worth the risks that high inflation entails.

So far, there is little evidence of the type of wage-price spiral seen in the 1970s, when workers demanded higher wages which then translated into higher prices for goods and services. This dynamic was partly driven by unions in key industries, where unorganized labor is more prevalent today.

Yet labor markets are already tight, which is why the Fed is determined to get inflation under control, says Carola Binder, assistant professor of economics at Haverford College. “It’s good to have a full-employment economy. But we’re already there … and I don’t think it’s justifiable to lower unemployment to help low-income workers,” she says.

The United States is far from alone in its dilemma. Prices have also risen in other major economies, notably in Europe, where energy and food bills have soared since Russia invaded Ukraine in February. UK, the annualized inflation rate reached 9% in April. (The US rate was 8.3%). The Bank of England and other central banks have started raising interest rates, but all eyes are still on the Fed, given its heft and huge volume of trade and dollar-denominated assets.

U.S. policymakers recognize that their monetary decisions have global effects, including on capital flows to emerging markets, says Gagnon, a former Fed official. But, he notes, “they don’t act on that belief except to the extent that it would rebound” and impact financial stability in the United States, in which case they factor it into their policy.

But the reality is that the Fed is the de facto central bank of the world, says Mark Blyth, professor of international economics at Brown University. He believes that if the Fed goes over rate increases, it could trigger “the mother of all capital flight” from riskier financial assets into US bonds and other securities. And this destabilizing scenario could remain in the hands of Fed policymakers who might otherwise want to tighten more aggressively.

“They’re going to talk about a good game,” he predicted. “And then raise [the benchmark rate] half a percent and see if it works.

Despite all the public complaints about inflation, most expect it to come down in the future. The University of Michigan survey found that consumers expect an inflation rate of 3% in five to 10 years, not much higher than the survey average of 2.8 % over the period 2000-2019. Bond markets are also pointing to modest future inflation, based on the premium paid for 10-year inflation-protected treasury bills.

None of this means the Fed will avoid a hard landing. But that doesn’t suggest a return to the persistent bouts of inflation that defined the 1970s.

“Some inflation was inevitable,” says Gagnon. “You just want to make sure people don’t think it’s permanent and so far they don’t.”

Edward N. Arrington