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Chances are not in favor of a smooth Fed landing

Federal Reserve Chairman Jerome Powell explained this week what he and his colleagues hoped to achieve with interest rate hikes that began last week. “The economy is gaining ground, with inflation falling and unemployment stable,” he told a conference of economists.

In 1965, 1984 and 1994, the Fed raised interest rates enough to reduce the economy’s overheating without accelerating the recession, he said, adding that it could have done the same in 2019 but for the Covid-19 pandemic.

Unfortunately, history is not on his side. Inflation is far from the Fed’s target and the labor market, by many meters, stricter than in previous mild landings, but the Fed starts with real interest rates – nominal rates adjusted for inflation – much lower, in fact deep negatively. In other words, not only is the economy already traveling above the speed limit, but the Fed has pressed the accelerator pedal to the floor. Chances are that a return to inflation at the Fed 2% target will require much higher interest rates and a greater risk of recession than the Fed or markets now expect.

The biggest contrast to previous mild landings was that in the past, the Fed only sought to prevent inflation from rising – not to actually push it. Today, however, it starts with core inflation, which excludes food and energy, above 5% using the Fed’s preferred price index, more than 3 percentage points above the target.

The history and models of the Fed itself are pretty clear: When inflation is very high, pushing it down requires dampening demand and raising unemployment so that workers and businesses can come to terms with lower wages and prices. However, interim forecasts released by Fed officials do not show this: They expect core inflation to fall to 4.1% at the end of this year, to 2.6% next year and to 2.3% in 2024 , while unemployment remains close to the 50-year low of 3.5% to 3.6% for the entire period.

Higher interest rates can reduce demand, such as waiting lists for new cars.


Photo:

Mario Tama / Getty Images

Until last fall, such “flawless deflation” seemed reasonable as supply chain disruptions were resolved and commodity prices, especially cars, fell from highs. However, progress in supply chains has been flooded with new breaks from Russia’s invasion of Ukraine and Covid-19 restrictions in China. Inflation, meanwhile, has spread far beyond commodities to a wider range of goods and services. Suppose commodity inflation slows to near zero before the pandemic. If services inflation continues at its recent rate, headline inflation will remain above 3%.

Supply disruptions, such as in the oil markets, had only a transient effect on inflation in the 1990s and 2000s, as the public expected inflation to return to around 2% and set wages and prices accordingly. The Fed expects the same this time, noting that bond markets and surveys show that inflation expectations for five to ten years from now are still close to 2%.

However, supply disruptions have been larger, broader and longer lasting than in the past, and bond investors now expect inflation to remain above 3% until 2024. Higher expected inflation makes it harder to reduce real inflation and mitigates the impact of the Fed’s monetary tightening. Since December, bond yields have risen sharply, but so has expected inflation, so real yields are still deeply negative. Fed officials predict that their federal funds target will peak at 2.8% next year. If inflation is above 3%, this is a negative real percentage.

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Negative real interest rates are necessary for a weak economy that needs stimulus, but today is just the opposite. Unemployment is 3.8% lower than at the beginning of any Fed tightening cycle in the last 70 years, except in 1969 (which ended in a recession). It is also below the Fed’s estimate of 4% for the “natural” unemployment rate, below which intensifies price and wage pressures. In addition, for three years they see unemployment remain below 4% and the economy exceeding the long-term potential growth rate of 1.8%. It is true that the natural rate of unemployment and possible growth are impossible to observe immediately and the Fed has done it wrong in the past. However, with record vacancies and wages rising rapidly, it is a good bet that unemployment is below and not above its natural rate today.

To be fair, there are quite a few unusual features in today’s economy that support the hypothesis of a smooth landing. Unlike in the past, high inflation now stems from strong demand that interacts with limited supply. Higher interest rates can reduce demand, such as the number of bidders per home or the waiting list for new cars, thus reducing prices but not the number of homes and cars sold. Jobs are 70% more than the number of unemployed. Reduced demand for labor could mean that the same number of employees will be hired, but with lower wages.

Second, the workforce shrank during the pandemic due to early retirement, childcare problems and Covid-19. As the pandemic subsides, the Fed expects the workforce to recover, allowing employment and output to grow rapidly without further pushing unemployment or pushing up wages.

However, history does not provide a great precedent for these things. If they do not fall out and supply chains are not resolved quickly, then the Fed will probably have to accept higher inflation – which Mr Powell said is not on paper – or raise interest rates until unemployment rises. Theoretically, this can happen without a recession. And that would be unprecedented.

A reversal of the US government yield curve has been seen as a warning sign of recession for decades and looks set to light up again. WSJ Dion Rabouin explains why an inverted yield curve can be so reliable in predicting a recession and why market observers are talking about it now. Illustration: Ryan Trefes

I write to you Greg Ip at greg.ip@wsj.com

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Chances are not in favor of a smooth Fed landing

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