Why Fed says fighting inflation is Job 1, despite recession risk

From stocks to housing to retailing, indicators of a slowing U.S. economy are flashing red. Consumer sentiment in a closely watched monthly survey by the University of Michigan fell in April to its lowest level in a decade. And it’s not just the United States: the International Monetary Fund recently marked down its forecast for global economic growth in 2022 to 3.6 percent, compared to a 4.4 percent estimate in January. 

This may all sound like bad news. But to the Federal Reserve, a slowdown could be just what is needed to tame inflation and reset expectations of where prices are headed after a torrid period of fiscal and monetary expansion. For its part, the Fed is trying to engineer a soft landing for the U.S. economy by raising interest rates and signaling more hikes to come. 

The risk is that the Fed’s inflation-busting cure could prove too strong and that, sooner or later, a recession will follow. That risk, which President Biden acknowledged Monday while insisting that a recession wasn’t inevitable, is what makes central banking as much art as science, for all the data crunching that goes into interest rate setting.

For Fed policymakers, it’s about finding the right balancing point between support and restraint, so the economy can flourish but not overheat. And it’s particularly perilous now: Even though the pandemic stimulus programs, which helped goose consumer demand, have already faded, inflation is running at 40-year highs.

“We don’t really understand recession dynamics all that well,” says Louise Sheiner, policy director for the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution. That makes it hard to gauge “exactly how much the Fed needs to move to get inflation down without [triggering] a bad dynamic where consumers get pessimistic and businesses get pessimistic.” 

Critics say the Fed was behind the curve last year as inflation picked up pace, stoked by stimulus spending and rock-bottom borrowing costs. Now the pendulum has swung the other way, with fears that policymakers will overshoot in tackling rising prices. 

Treasury Secretary Janet Yellen warned last week that the Fed faced “a very difficult economic situation” in trying to contain inflation without pushing the U.S. into a recession. “I think it’s conceivable there could be a soft landing. It requires both skill and luck,” she told reporters in Germany.

By law, the Fed’s job is to pursue – and often strike a balance between – the twin goals of price stability and full employment. Employers have been raising wages to recruit workers who have more options in a tight labor market and are also sitting on more household savings. Raising interest rates too abruptly could end that cycle just when more adults are returning to the workforce after the pandemic’s disruptions.  

In 1994, the Fed cooled inflation without tanking the economy, which continued to expand at a steady clip. But there’s no simple formula to follow, which is why soft landings are elusive, warns Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics. 

“We have many examples of the Fed fighting inflation and causing a recession,” he says. 

In 1994, inflationary pressures were largely domestic. Now the Fed has to weigh the impact of external supply shocks, from oil and grain to computer chips and lumber. Shortages have pushed prices of these and other goods higher, contributing to U.S. inflation. War in Ukraine and repeated pandemic lockdowns in China have only added to the disruption in recent months. 

The problem for central bankers is that while raising interest rates at home can dampen demand for imported goods, it doesn’t necessarily unblock supply chains. And regardless of where the Fed sets rates, the global supply chain will still need to find its own workarounds. 

In March, the Fed raised its benchmark interest rate by a quarter of a percentage point, after two years of near-zero. Earlier this month, it raised it again by a half-point to a range of 0.75-1.00%. 

Fed Chair Jerome Powell has signaled that two more half-point hikes are likely to follow in June and July. When asked on May 4 about the risk that tightening could hurt the economic recovery, Mr. Powell put an emphasis on long-term price stability. “There may be some pain associated with getting back to” 2% inflation, he said, adding that “the big pain over time is in not dealing with inflation and allowing it to become entrenched.” (The Fed’s inflation target is 2%.)

Polls show that inflation is top of mind for U.S. voters going into midterm elections. Lower-income consumers are hit disproportionately by higher gas and grocery prices. But the sentiment that inflation is bad, and that the government is to blame, is shared across economic classes and has forced the Biden administration on the back foot, since the White House has limited options to tackle inflation. 

Some left-leaning economists argue that, with wage growth lagging behind the inflation rate, the Fed should consider letting inflation stay above its target for a longer period in order to keep the recovery going. In this view, looser monetary policy that helps lift wages at the bottom of the income distribution may be worth the risks that high inflation brings. 

So far, there is little evidence of the kind of wage-price spiral seen in the 1970s, when workers demanded higher wages that then fed into higher prices for goods and services. That dynamic was partly driven by unions in key industries, where nonunionized labor is more prevalent now. 

Still, labor markets are already tight, which is why the Fed is determined to get a grip on inflation, says Carola Binder, an assistant professor of economics at Haverford College. “It’s good to have a full employment economy. But we’re already there … and I don’t think it’s justifiable to push unemployment lower to help low-income workers,” she says. 

The U.S. is far from alone in its dilemma. Prices have also been rising in other major economies including in Europe, where energy and food bills have spiked since Russia invaded Ukraine in February. In the U.K., the annualized rate of inflation hit 9% in April. (The U.S. rate was 8.3%.) The Bank of England and other central banks have begun raising interest rates, but all eyes are still on the Fed, given its heft and the sheer volume of dollar-denominated trade and assets. 

U.S. policymakers recognize that their monetary decisions have global effects, including on capital flows into emerging markets, says Mr. Gagnon, a former Fed official. But, he notes, “they don’t act on that belief except to the extent that it would rebound” and impact financial stability in the U.S., in which case they do factor this into their policy. 

But the reality is that the Fed is the world’s de facto central bank, says Mark Blyth, a professor of international economics at Brown University. He reckons that if the Fed overshoots in raising rates it could trigger “the mother of all capital flights” from riskier financial assets into U.S. bonds and other securities. And that destabilizing scenario could stay the hands of Fed policymakers who might otherwise want to tighten more aggressively. 

“They’re going to talk a good game,” he predicts. “And then raise [the benchmark rate] by half a percent and see if it works.”

For all the public gripes about inflation, most expect it to abate in the future. The University of Michigan survey found that consumers expect a 3% inflation rate in five to 10 years, not much above the survey average of 2.8% during 2000-2019. Bond markets also point to modest future inflation, based on the premium paid for inflation-protected 10-year Treasury bonds. 

None of which means that the Fed will avoid a hard landing. But it doesn’t suggest a return to the persistent bouts of inflation that defined the 1970s. 

“A certain amount of inflation was unavoidable,” says Mr. Gagnon. “You just want to make sure people don’t think that this is permanent and so far, they don’t.”