As the Federal Reserve hikes interest rates to lower inflation, more people will be out of work. Real wages (adjusted for inflation) will stagnate or fall. Businesses will fail. Those who can least afford it will suffer the most damage.
Still, if we’re lucky and all pauses go our way – most helpful would be an end to the war in Ukraine, which has led to spikes in food and energy prices – we could dodge a full-blown recession.
Instead, inflation could start to decline as higher borrowing costs introduced by the Fed restrain, but not destroy, consumer spending and business investment. In this “soft landing” scenario, which the central bank gave one version of in its latest projections last week, the economy would continue to expand, albeit at a much slower pace than last year. Unemployment would rise, but not dramatically.
But make no mistake: the Fed intends to crush inflation by any means necessary — even if it means a “hard landing,” with borrowing costs so high that the economy plunges into a job-killing recession.
“There’s always a risk of going too far or not going far enough,” Fed Chair Jerome Powell said during a news conference last week after the central bank approved a three-quarters-of-a-percentage-point hike in interest rates, the third of the year and the largest since 1994.
“But I would say the worst mistake we could make would be to fail, which is not an option,” he said. “We need to restore price stability, we really are, because. . . it is the bedrock of the economy.”
In other words, Powell, who was once criticized for not acting more aggressively when inflation reared its head last year, is now poised to comatose the economy if that’s what it takes to bail it out.
Nearly two years ago, Powell’s Fed passed a new framework to move closer to its congressional mandate to support full employment while maintaining stable prices. One important change: policymakers would make the mistake of dropping the unemployment rate and not curbing credit until inflation becomes a real scourge. At that point, inflation had been benign for nearly a decade, and Fed officials believed a less hawkish stance would give more people time to enter the workforce.
Now, inflation is public enemy #1, for reasons you’re tired of hearing about: pandemic disruptions to the workforce and global supply chains, outsize government stimulus, and the surge in energy prices fueled by sanctions on Russia for its attack on Ukraine was caused. And inflation is a global problem, with consumer prices rising in Canada and Mexico, the UK and parts of Europe and Asia.
Powell last week insisted the Fed is “not trying to create a recession now.” But the central bank has never reined in stubborn inflation without causing a downturn.
The federal funds rate affects a wide range of borrowing costs. As the rate increases, so does the cost of carrying credit card balances. New mortgages will have higher monthly payments, as will car loans. Borrowing is also becoming more expensive for many companies.
The Fed’s goal is to reduce the overheated demand for goods and services that has been driving prices up. When consumer spending slows, hiring typically falls, layoffs increase, and businesses invest less in plant and equipment.
“They lower inflation by making people poorer,” said Claudia Sahm, adviser and former White House and Federal Reserve economist.
All recessions — defined by the National Bureau of Economic Research “as a significant decline in economic activity that spreads across the economy and lasts more than a few months” — are bad. But some are worse than others.
The “dot-com” recession of 2001 was considered short and mild. Unemployment rose to 5.9 percent from 3.9 percent immediately after the eight-month downturn, a slower rise than in some previous recessions. The total loss of production was a kink on the long-term chart of economic growth.
By contrast, during the Great Recession, the unemployment rate rose from under 5 percent in late 2007 to 10 percent in the months after growth resumed. That was a level not seen since the 1981-82 recession. Production contracted in five of the six quarters gripped by the recession, including a devastating 8.5 percent annualized decline in the fourth quarter of 2008, the largest quarterly decline in 50 years.
The general view among economists is that a recession could feel more like 2001 than 2007-2009. The economy is growing, the financial system is solid and the unemployment rate is 3.6 percent, a five-decade low.
“Consumer credit has improved, savings are high and they have paid off much of their debt,” said Stephen Cecchetti, an economist at Brandeis International Business School and former head of the bank’s monetary and economic division for international settlements.
There is one important caveat: In the year leading up to the 2001 recession, inflation was less than half what it is today.
The severity of a downturn will depend on how quickly inflation falls towards the Fed’s 2% target.
Using the central bank’s preferred measure, inflation is expected to come in at 5.2 percent this year, and its forecast projects that rate to fall to 2.2 percent by 2024.
A rough rule of thumb, according to Cecchetti, is that the unemployment rate increases by 1 percentage point for every 1 percentage point fall in inflation. In that case, unemployment could rise above 6 percent as the Fed hikes 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 could be much more of a pullback.
Meanwhile, despite a strong labor market, consumers are in a bad mood. This will create a pandemic followed by soaring food and gas prices.
The housing sector and closely related industries such as furniture and appliance manufacturers are most at risk as the Fed wages its inflationary war. Also vulnerable are industries that perform best when consumers are free to spend, including hotels, restaurants, airlines, and essential goods and services.
How likely is a recession?
Economists put the chance of a downturn over the next 12 months at 1 in 3, according to consensus forecasts tracked by Bloomberg. That’s about as much as it was in the months leading up to COVID’s arrival, when the economy was booming and inflation seemed a thing of the past.
The consensus among CEOs is murkier. More than 60 percent of CEOs worldwide see a recession in their regions by the end of 2023, according to the latest survey from The Conference Board, a corporate think tank. 15 percent believe a recession is already underway.
Bond investors, hyper-adjusted to inflationary trends, have pushed short-term yields to levels not seen since 2007. Current bond yields show that while investors have major concerns, they don’t see a pullback as inevitable — not yet.
“Investors believe the economy will slow sharply in the coming months but will not suffer a recession,” said Mark Zandi, chief economist at Moody’s Analytics. “Of course there’s a lot of business scripts to write.”
The economy is at a crossroads. Powell said he sees a path to 2 percent inflation that doesn’t include a recession.
“We’re not trying to put people out of work, of course,” Powell said. “But we also think that without price stability you really can’t have the kind of labor market that we want.”
It remains to be seen how painful the costs of price stability will be.
Larry Edelman can be reached at email@example.com. Follow him on Twitter @GlobeNewsEd.