The US Federal Reserve has fully pivoted to fighting inflation and reducing demand in the economy. The central bank’s open market committee is expected to further tighten interest rates and end purchases of financial assets at meetings starting tomorrow.
That sounds right after prices have increased 8.5% in the last year for the average US consumer, far above the Fed’s target of 2%. Few economists think the Fed shouldn’t tighten monetary policy.
But the Fed is still playing a dangerous game: Its officials want to take enough demand out of the economy to maintain price stability, but if it goes too far, it could send the economy into a recession.
Some analysts think that result is inevitable—in the history of central banking, many attempts to slow the inflation end in a crash. A recent paper by Harvard economist and current Fed critic Larry Summers suggests that probability could be 100%. Other analysts, at the ratings agency Moody’s or megabank Goldman Sachs, put the chance of a near-term recession at around one in three.
Yet, even inside the Fed itself, there’s a hope this time might be different, that our weird semi-post-pandemic economy might provide the right conditions for something we haven’t seen in decades: A soft landing.
Imagine the economy as a hot air balloon. Pump too much energy in, and the balloon goes quite high. To return to the Earth, you need to let some of the hot air cool so you can descend, but if you move down too fast, the results could be catastrophic.
Now, with chair Jay Powell’s hand on the regulator, it’s time to figure out what may keep our balloon from plummeting.
The prototypical tightening cycle is what happened with Fed chair Paul Volcker in the 1980s: To fight rising inflation, he hiked interest rates dramatically, throwing the country into a two-year recession. Farmers famously surrounded the central bank with their tractors in protest.
But that severe reaction is not a guarantee. Alan Blinder, the Princeton economist, argues that since 1965, there have been 11 episodes of the Fed tightening interest rates, and seven have been fairly mild, with economic production falling less than 1%. Of the rest, three episodes—notably, the Volcker tightening—were intended as drastic responses to economic conditions. Two other episodes, the most recent, saw recessions following tightening episodes, but arguably from external causes: The 2008 financial crisis and the 2020 pandemic.
Powell is looking to three specific examples, in 1965, 1984, and 1994, when the Fed tightened monetary policy, lowered inflation, and saw no reduction in growth. “It is worth noting that today the economy is very strong and is well positioned to handle tighter monetary policy,” he said in a March speech.
Don’t get distracted by last week’s GDP report, which showed that US production fell 1.4% in the first quarter of 2022. The bulk of that fall is driven by a record level of imports, which shows the salient feature of the booming US economy: There is a lot of demand for goods, and increasingly for services, with consumers continuing to spend and businesses continuing to invest.
The US economy is expected to grow 3.7% this year by the International Monetary Fund. Even after the IMF reduced its forecast for US growth following Russia’s invasion of Ukraine, production is still expected to expand by 2.3% in 2023—which would equal the growth rates in 2018 and 2019. The unemployment rate is 3.6% after one of the fastest recoveries from a recession ever. And US consumers have perhaps $2 trillion in excess savings accumulated during the last two years, offering them a cushion as government spending continues to fall.
Arguably, all that gives the Fed some breathing room: As monetary policy tightens, consumer spending and business investment could keep the economy growing even as inflation slows.
Larry Summers has the opposite view: With the labor market this tight, businesses will have to keep increasing wages to attract workers. If the Fed had started hiking rates while more people were unemployed, businesses would have been able to cut wages more easily, but now it will have crater the economy to kill inflation.
A recent working paper co-authored by Summers looks to historical examples. When wage inflation has averaged above 5% and the unemployment rate has averaged below 4% in the same quarter, as it did in the first quarter of 2022, there is 100% chance of a recession in the next two years.
Summers has argued that the primary cause of excessive inflation is government spending, and the money it has put into consumers hands.
It’s clear the unprecedented fiscal response to the pandemic is having a major effect on the economy, supporting the highest growth and fastest labor market recovery in decades. Economists at the San Francisco Federal Reserve Bank have estimated that the American Rescue Plan added three percentage points to inflation by the end of 2021—which also implies that a significant chunk of current inflation is coming from somewhere else.
That is the behavioral changes the pandemic has forced upon the world. Businesses faced supply chain disruptions caused by lockdowns abroad and enforced closures at home. Meanwhile, parents had to stay home with children, immunocompromised people avoided crowds, and everyone spent more money on things that could be delivered than on in-person services.
Powell argues the Fed and other forecasters didn’t predict high inflation because they didn’t expect the pandemic to last as long as it did, with the winter outbreak of the omicron variant in particular sending prices soaring. The major hope for a soft landing is that the world’s stumble back towards normality will continue, and that prices will stop rising and show the Fed a clear path towards its 2% inflation target without having to raise rates too quickly.
There are good signs: Falling car prices, a major driver of inflation, is one promising indicator; another can be found in Amazon’s earnings last week, when the company said it’s past the rush of hiring and supply chain investment that defined it in 2021. And while the unemployment rate is low, labor force participation has yet to recover to pre-pandemic levels, suggesting there is still some pandemic slack in the labor market to moderate wage increases.
That’s why Russia’s invasion of Ukraine and chaos in global commodities markets are such a threat to the Fed right now. The institution’s tools are a blunt instrument to influence demand, but there’s little they can do to directly increase the supply of oil, grain, fertilizer or other vital resources whose prices are currently surging. As with most economic challenges, solving price rises may require supply-side action from other branches of government: Tariff reductions, tax increases, investments in supply chains, or new trade deals.
Perhaps most of all, a soft landing will require luck. The Fed’s monetary policy committee is making its decisions off of imperfect, often month-old data, in a time of rapid global change. The US central bank has faced a brutal recession and an unprecedented recovery, even as trade norms and technology reshape the dynamics of the economy. Maybe it’s due for a break.