The odds are against the Fed soft landing

Federal Reserve Chair Jerome Powell explained this week what he and his colleagues hoped to achieve with the rate hikes initiated last week. “The economy is making a soft landing, inflation is coming down and unemployment is holding up,” he told a conference of economists.

In 1965, 1984 and 1994, the Fed raised interest rates enough to cool an overheated economy without triggering a recession, he noted, adding that it may have done so in 2019, except for the Covid-19 pandemic.

Unfortunately, history is not on his side. Inflation is much further from the Fed’s target and the job market is in many ways tighter than previous soft landings. But the Fed starts with real interest rates – nominal interest rates adjusted for inflation – much lower, deeply negative in fact. In other words, not only is the economy already speeding above the speed limit, the Fed has floored the accelerator. Chances are that bringing inflation back to the Fed’s 2% target will require much higher interest rates and a greater risk of recession than the Fed or markets are now anticipating.

The main contrast to previous soft landings has been that the Fed has historically only attempted to keep inflation from rising – not actually to depress it. Today, however, it starts with core inflation excluding food and energy, above 5% using the Fed’s preferential price index, more than 3 percentage points above target.

The Fed’s history and its own models are pretty clear: when inflation is too high, it must be pushed down by dampening demand and raising unemployment so that workers and firms settle for lower wages and prices have to give. But the median forecasts released by Fed officials show nothing of the sort: They expect core inflation to fall to 4.1% by the end of this year, 2.6% next year and 2.3% in 2024 as unemployment nears remains at a 50-year low of 3.5%. to 3.6% for the whole period.

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


Mario Tama/Getty Images

Such “flawless disinflation” seemed plausible until last fall, when supply chain disruptions eased and prices of durable goods, particularly cars, fell from elevated levels. However, progress in supply chains has been swamped by fresh disruptions from the Russian invasion of Ukraine and Covid-19 restrictions in China. Inflation has now spread well beyond durable goods to a broader range of goods and services. Suppose commodity inflation falls to its pre-pandemic rate of around zero. If services inflation continues at its recent pace, headline inflation will remain above 3%.

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

But the supply disruptions have been bigger, broader and longer-lasting than in the past, and bond investors now expect inflation to stay above 3% into 2024. Higher expected inflation makes actual inflation harder to bring down and mitigates the impact of the Fed’s monetary tightening. Bond yields have risen sharply since December, but so has expected inflation, so real yields are still deeply negative. Fed officials expect their federal rate target to peak at 2.8% next year. If inflation is above 3%, that is a negative real interest rate.


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Negative real interest rates are necessary for a weak economy that needs stimulus, but today the exact opposite is the case. Unemployment is 3.8%, lower than when the Fed began a tightening cycle in 70 years except for 1969 (which ended in a recession). It’s also below the Fed officials’ estimate of 4% of the “natural” unemployment rate, below which price and wage pressures build. They also expect unemployment to remain below 4% for three years and the economy to exceed its long-term potential growth rate of 1.8%. It’s true that the natural unemployment rate and potential growth cannot be observed directly, and the Fed has misunderstood them in the past. However, with record job vacancies and rapidly rising wages, it’s a good bet that unemployment today is below, not above, its natural rate.

In fairness, there are some unusual characteristics of today’s economy that bode well for a soft landing. Unlike in the past, high inflation now results from strong demand combined with constrained supply. Higher interest rates can reduce demand, such as the number of bidders per home or the waiting list for new cars, causing prices to fall, but not the number of homes and cars sold. Job offers are 70% higher than the number of unemployed. Lower demand for labor could mean hiring the same number of workers, but at lower wages than usual.

Second, the workforce shrank during the pandemic due to early retirement, childcare issues and Covid-19. As the pandemic subsides, the Fed expects the labor force to recover, allowing employment and output to grow at a brisk pace without further pushing unemployment or pushing wages higher.

Still, history doesn’t provide many precedents for these things. If they don’t turn positive and supply chains don’t normalize quickly, the Fed will likely have to accept higher inflation — which Powell says is not on the horizon — or raise interest rates until unemployment rises. Theoretically, this can also be done without a recession. That too would be unprecedented.

An inversion in the US Treasury yield curve has been a warning sign of a recession for decades, and it looks set to flare up again soon. The WSJ’s Dion Rabouin explains why an inverted yield curve can so reliably predict a recession and why market watchers are now talking about it. Figure: Ryan Trefes

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