The warning signs are multiplying and Federal Reserve Chair Jerome Powell is struggling to explain how it can be avoided: U.S. recession is very likely if the Fed delivers the inflation-busting interest rate increases it has flagged.
The thing is though, he doesn’t need to explain.
The Fed has a dual mandate which states that monetary policy be calibrated to foster the economic conditions that achieve “maximum employment” and “stable prices.” Economic growth, in and of itself, is not a policy goal.
Of course, a decelerating or shrinking economy is more likely to result in rising job losses, and an expanding economy more likely to accelerate inflation. Price pressures can also rise in a slowing economy, potentially leading to ‘stagflation.’
But rightly or wrongly – and there is a compelling case to argue the latter – the Fed has made it clear it will tighten policy as much as is required to bring inflation back toward its 2% target from the current 40-year high of 8.6%.
Even though Powell on Wednesday stressed the Fed is not trying to induce recession, a Fed statement later in the week said achieving its inflation goal is “unconditional” – indicating that, unlike more recent cycles, ‘soft landings’ that avoid technical recession are not the ultimate goal.
Indeed the economy may already be close to recession, having shrunk 1.4% in the first quarter and, according to the Atlanta Fed’s latest projection, poised to post 0% growth in the second. The message from many Fed policymakers is that the central bank is prepared to push rates well into restrictive territory and if the price for that is period of contracting growth, so be it.
“The Fed doesn’t have a growth mandate, and there’s no harm in stating the obvious,” said John Silvia, economist and founder of Dynamic Economic Strategy.
FULL EMPLOYMENT?
The fact the Fed’s explicit jobs target is already met with a post-pandemic unemployment rate of 3.6% – close to the lowest in 50 years and what most economists would agree is full employment – gives the Fed ample wiggle room to focus on inflation.
The Federal Open Market Committee’s median projection is for an unemployment rate of 4.1% in 2024, up from 3.7% at the end of this year. This is higher than the previous forecasts in March of 3.6% and 3.5%, respectively, but still low historically.
Even if unemployment rises two full percentage points over the next 12-24 months, it would still be around the average over the past 75 years – even if you exclude the extraordinary COVID-related surge two years ago. And it would also be well below the 6.2% average rate over the past 50 years.
“We hadn’t seen … unemployment rates below 4% until a couple years ago. We’d seen it for one year in the last 50. So, a 4.1% unemployment rate with inflation well on its way (down) to 2%, I think that would be a successful outcome,” Powell told reporters on Wednesday.
This is the nub of it. The Fed can get away with slowing the economy – or even pushing it into reverse – because the unemployment rate is so low. Were the labor market in a weaker state, the Fed’s landing strip would be much shorter and narrower.
GORILLA IN THE ROOM
The Fed wants to tighten financial conditions enough to cool inflation, without torpedoing the labor market or economy. Knowing when to take its foot of the gas will be challenging, to say the least.
As Former Treasury Secretary Larry Summers notes, history shows that every time inflation has been above 4% and unemployment below 4%, recession has followed.
So far this year, U.S. financial conditions have tightened nearly 300 basis points, according to Goldman Sachs’s financial conditions index. That is mainly a result of falling equity prices and rising long rates.
Phil Suttle, founder of consultancy Suttle Economics in Washington, says the “gorilla in the room” is where the so-called ‘NAIRU’ is – the non-accelerating inflation rate of unemployment. That is the lowest level of unemployment that can exist in the economy before inflation starts to rise.
Always an imprecise exercise given difficulties in measuring spare capacity in real time, few doubt the pandemic and related labor market disruptions have pushed NAIRU higher. One academic paper in February estimated it rose to almost 6% late last year from around 4.5% before the onset of the pandemic.
Suttle reckons it is probably around 5% or higher, while Silvia reckons the Fed will start to get twitchy when the unemployment rate rises through 5%. Until then, however, there is little reason to believe the Fed will blink.
“Labor market data will be crucial in determining when the Fed twists and says ‘enough is enough’. It just won’t be where we used to think it was,” Suttle says.
