Hard landing or harder? The Fed may have to make a choice

The author is a former central banker and professor of finance at the University of Chicago Booth School of Business

In his testimony before Congress earlier this week, Federal Reserve Chairman Jay Powell indicated that “final interest rate levels are likely to be higher than previously expected” and “the restoration of price stability is likely to require that we time to maintain a restrictive stance”. This is how the hard Fed showed itself and markets collapsed accordingly. But a few weeks earlier, Powell had sent financial markets into the running when he said, “We can now say for the first time that the disinflation process has begun.” Accustomed to years of easy money, financial markets celebrate at the slightest sign that the Fed will loosen monetary policy and make its task more difficult. However, they are not the only market not currently cooperating.

Job markets have tightened even more, if anything, despite the Fed raising interest rates by 450 basis points since last March, and Friday’s strong payrolls figure hasn’t eased concerns. While the production of goods is slowing after the pandemic significantly increased consumption, the more labour-intensive services are now picking up sharply. Labor is hard to find, especially when it comes to hospitality and leisure. One reason is that the workforce is short of 3.5 million workers compared to pre-Covid projections. Older workers understandably quit during the pandemic, and many did not return. Pensions are still continuing at an accelerated pace. And tragically, as Powell pointed out, Covid-19 has also ended the lives of half a million workers in the US, while a slower rate of immigration has resulted in about a million fewer workers than expected.

Additionally, given the challenging nature of leisure and hospitality jobs, workers have sought opportunities in other areas of the economy. And perhaps more importantly, companies are holding on to their employees precisely because hiring has been so difficult. Until they are confident that the economy will slow down and they won’t need that workforce, and maybe until they see enough unemployment around them to signal that hiring won’t be difficult going forward, labor hoarding can be continued.

Other markets are also stagnating. For example, home sales in the US have slowed significantly, but home prices have generally held up, likely because not much supply is coming to the market. Because mortgage rates have risen so much over the past year, a homeowner with a 30-year 4 percent mortgage will have to shell out a lot more monthly payments when upgrading to a slightly better home with a new 7 percent mortgage. Because she can’t afford to buy, she doesn’t sell. And because this limits the supply of housing in the market, there is only moderate downward pressure on prices.

Finally, inflation is trending downward as pandemic-related supply chain disruptions and war-related commodity supply disruptions are now being addressed.

Belief in painless “flawless disinflation” and a soft landing lead to a self-reinforcing equilibrium in which few believe the Fed has much more to do. As a result, workers are not being laid off, financial asset and housing prices are holding up, and households have the jobs and wealth to keep spending. But without some slack in the jobs market, the Fed cannot feel comfortable pausing its efforts.

Therefore, to get the job done, the Fed must force markets to abandon their belief that disinflation will only be accompanied by minor job losses. In fact, a recent study by Stephen Cecchetti and others suggests that every disinflation since the 1950s has been associated with a significant rise in unemployment.

There is a risk that the Fed will remove a soft landing with modest job losses from the list of possible outcomes. The first, evidenced by Powell’s questioning during his congressional testimony, is that politicians will be furious when the Fed torpedoes a recovery it just bought with trillions of dollars in fiscal spending. The Fed is not immune to the wrath of Congress.

Second, the benign balance can turn into a malignant one. Markets could be having their Wile E. Coyote moment. Layoffs may lead to more layoffs as companies feel confident they can rehire if the need arises. In turn, laid-off employees may be forced to sell their homes, depressing house prices and reducing household wealth. Unemployment and reduced wealth may affect household spending, which in turn will hurt corporate profits. This will lead to more layoffs, falling financial markets and financial sector stress, and even more subdued spending. . . We could end up with a deeper recession than currently expected because it’s hard to get even a little bit of unemployment.

Of course, the Fed could then revive the economy by lowering interest rates, but it must be wary of doing so until it sees enough slack in the job market. If things spin too fast, the markets celebrate and work remains unfinished. But if you wait until there is enough slack, layoffs could develop a momentum of their own.

Then the Fed is tempted to be more ambiguous, maintain a soft landing on the menu and pray for flawless disinflation. If so, the Cecchetti study warns that the ultimate unemployment needed to contain inflation could be much higher. The Fed’s only realistic options might be a hard landing and an even harder landing. It might be time to make a choice.