With credibility at stake, Fed fires new volley at inflation

Having spent the past year single-mindedly fighting inflation, America’s central bank now faces a dilemma. Its inflation fight may be triggering an equally big problem: a recession in the United States. 

If Federal Reserve Chair Jerome Powell can bring down inflation and avoid a deep recession, he will have successfully negotiated a rough passage for the economy. But if his inflation battle proves ineffective, he will further damage the Fed’s credibility, which is already tarnished with costly mistakes last year.

“Credibility is important for everybody, but central banks especially, because their prime function over the centuries has been to preserve the value of money,” says Michael Bordo, an economic historian at Rutgers in New Brunswick, New Jersey. “And when that gets eroded, that is terrible.” 

On Wednesday, the Fed acknowledged the leadership challenge it faces. It stuck to its inflation-fighting mandate, hiking a key bank lending rate by a quarter of a percentage point, bringing interest rates to their highest level since 2007, the eve of the Great Recession. But it also signaled that those rate hikes could be coming to an end. Its post-meeting statement referred to the possibility of “some additional firming” of rates, as opposed to previous statements’ references to “ongoing increases.” 

In essence, the central bank is preparing financial markets and the public for a future pivot point where it stops fighting inflation and either takes a neutral stance or starts to support a weakening economy. But that time is not yet.

“We have to bring inflation down to 2%,” Mr. Powell said at a press conference Wednesday. “There are real costs to bring about 2% [inflation], but the costs of failing are much higher. ... You can have a long series of years where inflation is high and volatile and it’s hard to invest capital. It’s hard for an economy to perform well.”

Mr. Powell and the Fed missed the boat when inflation began to rise two years ago, many economists say. At the time, the Fed argued the jump in prices was temporary, driven by pandemic-related supply chain shortages rather than an increase in demand. After a costly year of inaction in which headline inflation surged to 40-year highs, the Fed finally made a U-turn almost exactly a year ago and began to raise interest rates in a bid to slow the economy and bring inflation down. Wednesday’s move, though smaller than the half-point hike that had been widely expected until recently, marks the ninth rate hike in the past year.

A test for Powell

Mr. Powell’s single-minded aggressiveness has helped rebuild his reputation. “I have never been a big fan” of the Fed chair, says Charles Calomiris, a Columbia Business School professor and former chief economist of the Office of the Comptroller of the Currency. “But you know, I’ve been impressed that he’s actually been fairly straight. He’s actually been honest about his mandate to maintain a long-term inflation target.”

That stick-to-it quality may be sorely tested now that the economy is looking increasingly fragile, especially in the tech and banking sectors. Vulnerable industries typically wobble as interest rates rise, making it more expensive to take out new loans and service some forms of existing debt. Such periods call for extremely fine judgment.

Raise rates too high and the economy sinks into a deep recession. Stop raising rates too early and the U.S. could get something even worse: a slow-growth economy with inflation that stays stubbornly high, a condition known as stagflation. After such an episode in the 1970s, the Fed under Chair Paul Volcker raised rates to 20%, sending the economy into a deep recession but inaugurating a quarter century of low-inflation growth.

These periods – when curbing inflation can impose short-term hardship on the economy – also give rise to growing industry and political criticism of the Fed. “It takes a certain amount of courage to be able to go against the pressures that are coming from the Congress and the financial markets,” says Mr. Bordo of Rutgers.

In another sense, however, this period of perceived economic vulnerability helps the Fed. If markets and businesses believe that the Fed is going to do what it said it would do, then typically banks and other lenders grow cautious and start to turn away borrowers or charge them more for taking out loans. Companies delay plans for expansion and begin to lay off workers. These moves, in essence, do the Fed’s work by slowing the economy without the central bank having to boost rates further.

In recent days, economists have tried to predict the effects of such private-sector moves, suggesting they might slow the economy by the same amount as a Fed interest rate hike of anywhere between 0.5 and 1.5 percentage points.

“The events of the last two weeks are likely to result in some tightening credit conditions for households and businesses,” Mr. Powell said at the press conference. “The question is, how significant will this credit tightening be and how sustainable?”

Bank troubles to address

One of the big concerns is that a Fed-engineered slowdown could trigger a banking crisis. The collapse of two banks earlier this month has set off a wave of worries that other banks will fail. 

“The core of what crisis-fighting requires is speed, flexibility, and clout,” says Robert Bruner, a professor of business administration at the University of Virginia at Charlottesville and co-author of “The Panic of 1907.” “You really have to intervene fast.” So far, he’s cautiously optimistic that regulators can contain the fears.

Although regulators weren’t able to prevent an old-fashioned run from collapsing one of the failed banks, the Fed along with the U.S. Treasury and the Federal Deposit Insurance Corp. did step in afterward to avoid similar problems elsewhere. The regulators used a special provision to bail out all the failed banks’ depositors, even those with more than the maximum insured by the FDIC, and loans to the banks for bonds at their par value rather than their diminished market value.  

U.S. bankers are working on backstopping First Republic, whose shares have dropped nearly 90% this month. And on Sunday, the Swiss government engineered the buyout of long-troubled Credit Suisse by that nation’s largest bank, UBS.

“You need a good story”

Mr. Powell also has some room for maneuvering, says Pierre Siklos, an economics professor at Wilfrid Laurier University in Waterloo, Ontario. As Fed chair, he has the power not only to act but also to shape public expectations through what he says.

“You need a good story, a story that’s believable to the financial analysts – those who are experts – and the general public; [then] they can say, ‘Yeah, that makes sense,’” he says. “The language that you use and the story that you provide are critical.”     

That’s what President Franklin Roosevelt did in his first fireside chat, a few days after his inauguration, when he told Americans what he was doing to end the bank runs of the Great Depression, says Andrew Metrick, director of the Yale Program on Financial Stability and former chief economist at the White House Council of Economic Advisers. It’s what Mario Draghi, as head of the European Central Bank, did in 2012 when in the midst of a currency crisis he uttered the now-famous words: “The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Both men soothed fears and solved the financial problems of their day, says Mr. Metrick. “Just be as clear as possible about what it is that the government can and will do, and do it in a credible way.”

Ultimately, though, Mr. Powell’s leadership may be judged by how well his words match the economy’s performance, says Mr. Bordo of Rutgers. “The only way Powell is going to come out of this looking good is if they pull it off – in other words, if we don’t have a recession or it’s a mild one and inflation goes down to 2% and we don’t have a huge banking panic.”