The Fed’s aggressive rate hikes increase the likelihood of a recession

WASHINGTON (AP) – Federal Reserve Chair Jerome Powell has vowed to do whatever it takes to curb inflation, which is now raging at a four-decade high and defying past efforts by the Fed to tame it .

Increasingly, it seems, this could require one painful thing the Fed has been trying to avoid: a recession.

A worse-than-expected inflation report for May – consumer prices rose 8.6% year-on-year, the biggest jump since 1981 – prompted the Fed to hike interest rates by three quarters of a point on Wednesday.

Not since 1994 has the central bank raised interest rates so much at once. And until Friday’s nasty inflation report, traders and economists had expected interest rates to rise by just half a percentage point on Wednesday. There are also a few more hikes to do.

The “soft landing” the Fed was hoping for — bringing inflation to its 2% target without derailing the economy — will be both more difficult and riskier than Powell had anticipated. Every rate hike means higher borrowing costs for consumers and businesses. And every time potential borrowers find borrowing rates prohibitively expensive, the resulting drop in spending hurts confidence, job growth and overall economic health.

“There’s a way for us to get there,” Powell said Wednesday, referring to a soft landing. “It doesn’t get any easier. It’s getting more challenging”

It’s always been difficult: the Fed hasn’t managed to pull off a soft landing since the mid-1990s. And Powell’s Fed, slow to recognize the magnitude of the inflationary threat, must now catch up with an aggressive series of rate hikes.

“They tell you, ‘We’re going to do whatever it takes to get inflation to 2%,'” said Simona Mocuta, chief economist at State Street Global Advisors. “I hope the (inflation) data won’t force them to do whatever they are willing to do. There will be costs.”

According to Mocuta, the risk of a recession is now probably 50:50.

“It’s not that it can’t be avoided,” she said. “But it’s going to be hard to avoid.”

The Fed itself concedes that higher rates will do some damage, although it doesn’t foresee a recession: On Wednesday, the Fed forecast the economy to grow about 1.7% this year, a sharp downgrade in growth from 2, 8% they had forecast march. And unemployment is expected to still average a low 3.7% by the end of the year.

But at a press conference on Wednesday, Powell dismissed any notion that the Fed’s price for taming inflation would inevitably be a recession.

“We’re not trying to create a recession,” he said. “Let’s get that straight.”

However, economic history suggests that aggressive, growth-destroying rate hikes may be necessary to finally bring inflation under control. And typically, that’s a recipe for a recession.

Indeed, since 1955, every time inflation has been higher than 4% and unemployment has fallen below 5%, the economy has plunged into recession within two years, according to a paper released this year by former Treasury Secretary Lawrence Summers and his Harvard University colleague Alex Domash. The US unemployment rate is now 3.6% and inflation has been above 8% every month since March.

Inflation in the United States, which had been under control since the early 1980s, rebounded with a vengeance just over a year ago, largely due to the economy’s stronger-than-expected recovery from the pandemic recession. The recovery caught businesses by surprise, leading to shortages, delayed deliveries – and higher prices.

President Joe Biden’s $1.9 trillion stimulus package in March 2021 added extra warmth to an already warming-up economy. So did the Fed’s decision to continue the easy money policy — keeping short-term interest rates at zero and pumping money into the economy by buying bonds — it made two years ago to help the economy through the pandemic to lead.

The Fed only started raising interest rates three months ago. Through May, Powell vowed to keep raising rates until the Fed sees “clear and compelling evidence that inflation is coming down.”

Some of the factors that drove the economic recovery have now disappeared. The federal aid payments are long over. Americans’ savings, swollen by government stimulus controls, are back below pre-pandemic levels.

And inflation itself has eaten up Americans’ purchasing power, allowing them to spend less in stores and online: After adjusting for higher prices, average hourly wages fell 3% last month from a year earlier, the 14th straight decline. On Wednesday, the government reported that retail sales fell 0.3% in May, the first drop since December.

Now rising interest rates will put even more pressure on the economy. Home and car buyers will face higher borrowing costs, and some will delay or reduce their purchases. Businesses will also pay more for loans.

And there’s another by-product of Fed rate hikes: the dollar is likely to rise as investors buy US Treasuries to take advantage of higher yields. A rising dollar hurts US businesses and the economy by making American products more expensive and more difficult to sell abroad. On the other hand, it makes imports into the United States cheaper, helping to alleviate some inflationary pressures.

The US economy remains strong. The job market is booming. Employers created an average of 545,000 jobs per month last year. Unemployment is near a 50-year low. And there are now about two job openings for every unemployed American.

Families are not buried in debt like they were before the Great Recession of 2007-2009. Banks and other lenders have not piled up risky loans like they did back then.

Still, Robert Tipp, chief investment strategist at PGIM Fixed Income, said recession risks are rising, and not just because of the Fed’s rate hikes. The growing fear is that inflation is so stubborn that it could only be defeated by aggressive rate hikes that are threatening the economy.

“The risk has increased,” said Tipp, “because the inflation numbers were so high, so strong.”

All of this makes the Fed’s inflation-dampening, recession-avoiding act even more insidious.

“It’s going to be a balancing act,” said Thomas Garretson, senior portfolio strategist at RBC Wealth Management. “That will not be easy.”

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