The Federal Reserve (Fed) should soon learn what gymnasts already know: it’s always hard to land softly. Inflation having reached its highest level in 40 years and continuing to accelerate, the American central bank decided on May 4, as anticipated, to raise its main key rate by half a percentage point, i.e. the highest sharp rise since 2000. The Monetary Policy Committee (FOMC) has also announced that “further increases will be justified”.
Fed Chairman Jerome Powell said there was a “good chance” of achieving a “soft landing” for the US economy. According to him, this rise in rates should not lead to a recession or a worsening of unemployment if “the economic and financial conditions evolve in a manner consistent” with the expectations of the central bank.
This is the second of seven rate hikes scheduled for 2022 – following a quarter-point increase in March. The Fed is thus trying to cool consumer demand and slow the rise in prices. The US central bank and forecasters are now expecting inflation to fall back below 3% and unemployment to remain below 4% in 2023.
Our recent research, however, suggests that this ‘soft landing’ remains highly unlikely and that there is indeed a strong likelihood of a recession in the near future.
Indeed, high inflation and low unemployment are two strong predictors of future recessions. Since the 1950s, whenever inflation has exceeded 4% and the unemployment rate has been below 5%, the US economy has experienced a recession within two years.
However, inflation is now 8.5% over one year and the unemployment rate 3.6%, which suggests that a recession will be very difficult to avoid.
The Fed is late
Inflation remains fundamentally caused by an excess of money in relation to goods available for purchase. However, in the short term, the supply of goods in the economy remains more or less fixed – fiscal or monetary policy cannot change this. The job of the Fed is therefore to manage the total demand in the economy so that it balances out with the available supply.
When demand exceeds supply too much, the economy begins to overheat and prices rise sharply. By our assessment, measures of this overheating—such as strong demand growth, shrinking inventories, and rising wages—have begun to play out in the economy throughout 2021. But the new operational framework that the Fed adopted in August 2020 prevented it from acting until sustained inflation was already apparent.
Consequently, the US central bank now appears very late in its response to the overheating economy.
To curb runaway inflation, the Fed will now seek to raise interest rates to dampen consumer demand. The resulting increase in borrowing costs can contribute to slowing economic activity by discouraging consumers and businesses from making new investments. However, this increase in borrowing costs also risks causing major economic disruption and steering the economy into a recession.
By “soft landing”, the Fed thus intends to achieve a situation in which interest rates rise and demand falls sufficiently to bring down inflation, but without curbing economic growth.
Nevertheless, the story of the “soft landings” does not inspire optimism. Indeed, we have found that whenever the Fed has applied the brakes hard enough to bring inflation down significantly, the economy has entered a recession. Although some have argued that there have already been several instances of soft landings over the past 60 years, including 1965, 1984, and 1994, we show in our analysis that those periods bear little resemblance to the present moment.
In all three episodes, the Fed was indeed operating in an economy where unemployment was significantly higher, price inflation lower, and wage growth weaker. In these historical examples, the central bank had also raised interest rates well above the rate of inflation – unlike today, where inflation is 8.5% when interest rates are expected remain below 3% until 2023.
The Fed had also acted early to prevent inflation from getting out of hand, rather than waiting until inflation was already excessive.
A recession more likely than not
One of the reasons why the Fed’s challenge appears particularly difficult is that the labor market today remains tighter than ever, which means that companies’ demand for labor far exceeds the supply of labor. of work available. This situation therefore implies that companies must increase wages to attract new workers.
Usually, the unemployment rate is used as an indicator of the tightness of the labor market. However, unemployment remains very low and the Fed expects it to fall further. But our research shows that the pressure to raise wages seems to be even stronger than what the unemployment rate indicates. Indeed, the number of job offers has never been so high and employees are leaving their positions at a record rate, both important factors for the increase in wages.
In a sense, wages are the ultimate measure of core (i.e. seasonally adjusted) inflation. More than two-thirds of business costs today relate to labour. The increase in wages, which today has reached a historic rate of more than 6% and which is accelerating, is therefore exerting significant upward pressure on inflation.
As a result, there is little reason to be optimistic about the possibility of slowing inflation to the Fed’s target range of 2%. According to our analysis, current wage growth implies inflation above 5%. History also shows that wage growth does not slow without a significant increase in unemployment and a recession.
The U.S. economy also continues to face additional inflationary pressures from rising grain and energy prices due to the war in Ukraine and further supply chain disruptions, with Covid-19 imposing new blockages in China. These factors threaten to further exacerbate inflation in the coming year.
According to our assessment, this inflation problem therefore appears unlikely to be resolved without a significant economic slowdown. All in all, the combination of an overheating economy, rising wages, lagging Fed policy and recent supply shocks means that a recession within the next two years is certainly more likely than ‘unlikely.