What a mess.
And here’s the kicker: Times will most likely get tougher before they get better.
As the Federal Reserve drives up interest rates in a high-stakes bid to bring down inflation, more people will be out of a job. Real wages (adjusted for inflation) will stagnate or fall. Businesses will fail. People who can least afford it will take the biggest hit.
Instead, inflation might gradually recede, as the higher borrowing costs engineered by the Fed restrain but don’t crush consumer spending and business investment. In this “soft landing” scenario, a version of which was laid out by the central bank last week in its most recent projections, the economy would continue to expand, though at a far slower pace than last year. Unemployment would climb but not dramatically.
But make no mistake: The Fed intends to break the back of inflation by any means necessary — even if that means a “hard landing,” with borrowing costs jammed so high the economy nose-dives into a job-killing recession.
“There’s always a risk of going too far or going not far enough,” Jerome Powell, the Fed’s chairman, said during a news conference last week after the central bank approved a three-quarters of a percentage point increase in the benchmark federal funds rate, the third of the year and the largest since 1994.
“But I will say the worst mistake we could make would be to fail, which it’s not an option,” he said. “We have to restore price stability, we really do, because. . . it’s the bedrock of the economy.”
In other words, Powell, once slammed for not acting more aggressively when inflation reared its head last year, is now willing to put the economy in a coma if that’s what’s needed to save it.
Nearly two years ago, Powell’s Fed adopted a new framework for approaching its mandate from Congress to support full employment while maintaining stable prices. A key change: Policy makers would err on the side of letting the jobless rate fall, and not tighten credit until inflation became a true scourge. At the time, inflation had been benign for almost a decade, and Fed officials believed a less hawkish stance would provide time for more people to get into the job market.
Now inflation is Public Enemy No. 1 for reasons you’re tired of hearing about: pandemic disruptions to the workforce and global supply chains, overgenerous government stimulus aid, and the surge in energy prices caused by sanctions against Russia for its attack on Ukraine. And inflation is a global problem, with consumer prices surging in Canada and Mexico, Britain, and parts of Europe and Asia.
Powell insisted last week that the Fed isn’t “trying to induce a recession now.” But the central bank has never brought unruly inflation to heel without causing a downturn.
The federal funds rate influences a broad range of borrowing costs. As the rate rises, so does the expense of carrying credit card balances. New mortgages will have higher monthly payments, as will car loans. It also becomes more costly for many businesses to borrow.
The Fed’s goal is to reduce the superheated demand for goods and services that has caused prices to mount. As consumer spending slows, hiring typically tails off, layoffs increase, and businesses invest less in plants and equipment.
“They get inflation down by making people poorer,” said Claudia Sahm, a consultant and former White House and central bank economist.
All recessions — defined by the National Bureau of Economic Research “as a significant decline in economic activity that is spread across the economy and lasts more than a few months” — are bad. But some are worse than others.
The 2001 “dot-com” recession was considered short and mild. Unemployment went from 3.9 percent to 5.9 percent in the immediate aftermath of the 8-month downturn, a smaller runup than seen in some earlier recessions. The total loss of output was a blip on the long-term chart of economic growth.
During the Great Recession, by contrast, the jobless rate soared from below 5 percent at the end of 2007 to 10 percent in the months after growth resumed. That was a level that hadn’t been seen since the 1981-82 recession. Output shrank in five of the six quarters covered by the recession, including a devastating 8.5 percent annualized drop in the fourth quarter of 2008, which was the largest quarterly contraction in 50 years.
The general view of economists is that if there is a recession, it could feel more like 2001 than 2007-2009. The economy is growing, the financial system is solid, and unemployment, at 3.6 percent, is near a five-decade low.
“Consumers’ credit quality is up, savings are high, and they’ve paid down a lot of their debt,” said Stephen Cecchetti, an economist at the Brandeis International Business School and a former head of the monetary and economic department at the Bank for International Settlements.
There is an important caveat: In the year leading up to the 2001 recession, inflation was running at less than half the rate than it is today.
The severity of any downturn will depend on just how quickly inflation comes down to the Fed’s 2 percent target.
Using the central’s bank’s preferred measure, inflation is expected to run at 5.2 percent this year, and its projection is for that rate to fall to 2.2 percent in 2024.
A rough rule of thumb, according to Cecchetti, is that the jobless rate rises 1 percentage point for each 1 percentage-point drop in inflation. If so, unemployment could climb above 6 percent as the Fed lifts interest rates. That’s about 2 percentage points higher than the central bank’s unemployment estimate, and a warning that the Fed’s hoped-for soft landing might be much more of a white-knuckle flight.
Meanwhile, consumers are in a bad mood even with a strong job market. That’s what a pandemic followed by soaring food and gas prices will do.
Most at risk as the Fed wages its inflation battle are the housing sector and industries closely tied to it, such as furniture and appliance makers. Also vulnerable are industries that do best when consumers are spending freely, including hotels, restaurants, airlines, and discretionary goods and services.
Just how likely is a recession?
Economists put the odds of a downturn over the next 12 months at 1 in 3, according to the consensus of forecasts tracked by Bloomberg. That’s about the same as they were in the months before COVID arrived, when the economy was humming and inflation seemed like a thing of the past.
The consensus among chief executive officers is gloomier. More than 60 percent of CEOs globally see a recession in their regions by the end of 2023, according to the latest survey by The Conference Board, a corporate think tank. Fifteen percent believe a recession is already underway.
Bond investors, who are extremely attuned to inflation trends, have sent short-term yields to levels not seen since 2007. Current bond yields indicate that while investors have deep concerns, they don’t see a contraction as inevitable — yet.
“Investors believe the economy will slow sharply in coming months but will not suffer a recession,” said Mark Zandi, chief economist at Moody’s Analytics. “Of course, there is a lot of economic script to be written.”
The economy is at a crossroads. Powell said he sees a path to 2 percent inflation that doesn’t involve a recession.
“We don’t seek to put people out of work, of course,” Powell said. “But we also think that you really cannot have the kind of labor market we want without price stability.”
What remains to be seen is just how painful the cost of price stability is.