Why the Federal Reserve will not be easing its battle in opposition to inflation anytime quickly
Federal Reserve Chairman Jerome Powell speaks during a Fed Listens event in Washington, DC, U.S., Friday, September 23, 2022. Federal Reserve officials gave their clearest signal yet this week that they are ready to a Recession as a necessary compromise to regain control of inflation.
Al Drago | Bloomberg | Getty Images
Think of Federal Reserve Chair Jerome Powell as a gymnast sprinting across the mat, spiraling, twisting, churning, then squirming through the air trying to make sure he’s still perfectly on his feet lands.
That’s monetary policy in this era of rapid inflation, dwindling economic growth and heightened fears of what could go wrong. Powell is that gymnast standing on the economical version of an Olympic mat and making sure everything goes right.
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Because when something goes wrong, it can go very wrong.
“They have to survive the landing,” said Joseph Brusuelas, chief economist at RSM. “It’s the bottom end of the economic ladder that’s going to carry the burden if the Fed doesn’t sustain the landing properly. Their spending will fall and they’ll have to draw on savings and 401(k)s to make ends meet.”
Consumers, pressured by ever-rising prices, are already saving to cover their costs.
According to the Bureau of Economic Analysis, the personal savings rate was just 3.5% in August. That was just above a 3% rate in June, which was the lowest in 14 years and dates back to the early days of the financial crisis.
The prices of everyday items have increased to an extraordinary extent. Eggs were up 40% in August from a year earlier, butter and margarine were up almost 30% and gasoline, despite falling 10.6% on the month, was still more than 25% ahead of the same point in 2021.
The consequences of not bringing this under control could be severe, just as they could be if the Fed goes too far in its bid to restore price stability to the US economy.
Brusuelas said a worst-case scenario would look something like a 5.5% unemployment rate and 3.5 million jobs lost, as companies have to lay off workers to cope with the economic slowdown and rising costs associated with an economic slowdown rampant inflation would occur.
The risk of failure
As it stands, the economy is very likely headed for a recession anyway. The question is how much worse it can end up.
“It’s not about whether we’re going to have a recession or not, but when we’re going to have it and how deep the recession is,” Brusuelas said. “My feeling is that we are in a recession in the second quarter of 2023.”
The Fed can’t just keep raising rates when the economy slows. It must rise until it reaches an equilibrium where it slows the economy enough to correct the complex mismatches between supply and demand, but not so much that it causes deeper, unnecessary pain. According to the Fed’s latest outlook, policymakers expect to continue into 2023, with interest rates about 1.5 percentage points off current levels.
“If the Fed overdoes it, you’re going to have a much deeper recession with higher unemployment,” Brusuelas said.
The main fear of central bank critics is that the Fed will go too far and dampen the economy too much.
They say there are tangible signs that the 3 percentage point rate hike in 2022 is on target and the Fed can now pause to let inflation come down and the economy recover, albeit slowly.
“The Fed could exit today and inflation will return to acceptable levels next spring,” said James Paulsen, chief investment strategist at The Leuthold Group. “I really think the war on inflation has been won. We just don’t know.”
Paulsen looks at things like falling prices for commodities, used cars, and imported goods. He also said prices of technology-related items are falling while retail inventories are rising.
On the labor market, he said the balance of wage growth this year has come from the supply side of the economy that the Fed is looking to boost, not the demand side that has been fueling the inflation explosion.
“If they want, they can cause an unnecessary recession,” Paulsen said. “I just don’t know why they want to do that.”
Paulsen is not alone in his criticism. There are calls on Wall Street for the central bank to back off on monetary tightening and watch the economy evolve from here.
Christopher Harvey, head of equity strategy at Wells Fargo, said the message from the Fed, particularly Chair Jerome Powell, that it was ready to inflict “some pain” on the economy was being interpreted as a central bank ready to carry on “until.” something breaks”.
“What’s worrying is the apparent downplaying of capital market signals as the Fed heads towards its 2% inflation target,” Harvey said in a note to clients. “Therefore these signals need to get louder (ie even lower stocks and wider spreads) before the Fed acts.
No less an authority than the United Nations issued an agency report on Monday in which the UN Conference on Trade and Development warned of the impact that rate hikes could have around the world.
“Current practices are harming vulnerable people everywhere, particularly in developing countries. We need to change course,” UNCTAD Secretary-General Rebeca Grynspan said at a press conference in Geneva, according to a Reuters report.
However, the data suggests the Fed still has work to do.
The forthcoming CPI report is expected to show that the cost of living continued to rise in September. The Cleveland Fed’s Nowcast tracker of items in the broad basket of goods and services, which the Bureau of Labor Statistics uses to calculate CPI, shows another 0.5% gain excluding food and energy, for a 6.6% increase % YoY. Including food and energy, the headline CPI forecast increases of 0.3% and 8.2%, respectively.
While critics argue that these types of data points are backward-looking, the Fed faces an additional visual problem after downplaying inflation when it first began to rise significantly more than a year ago and acting too late.
That lifts the burden on policymakers to tighten further to avoid a scenario like that of the 1970s and early 1980s when then-Chairman Paul Volcker had to drag the economy into a severe recession to quash inflation once and for all to stop.
“This is nowhere near the ’70s for many reasons,” said Steve Blitz, chief economist at TS Lombard. “But I would argue that they are still too optimistic that the inflation rate will slow down on its own.”
For their part, the Fed officials have stuck to the company line that they are willing to do whatever it takes to halt price increases.
San Francisco Fed Chairwoman Mary Daly spoke strongly about the human consequences of inflation, telling an audience on Tuesday that she had heard about it from her constituents.
“Right now, the pain I’m hearing, the suffering people are telling me about what they’re going through, is on the inflation side,” she said during a talk at the Council on Foreign Relations. “They worry about their everyday life.”
Daly specifically addressed the wage issue, saying one person told her, “I run fast and fall behind every day. I work as hard as I can and keep falling behind.”
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