JThe Federal Reserve will likely soon learn what gymnasts already know: Landing is tough.
As inflation hit a new 40-year high and continues to accelerate, the Fed raised interest rates by half a percentage point at the end of its May 4, 2022 meeting. the second of seven rate hikes scheduled for 2022 — following a quarter-point increase in March — as the Fed tries to calm consumer demand and slow rising prices.
By raising interest rates, the central bank hopes to achieve a proverbial “soft landing” for the US economy, in which it is able to rein in rapid inflation without driving up unemployment or triggering a recession. The Fed and professional forecasters expect inflation to drop below 3% and unemployment to stay below 4% in 2023.
Our recent research, however, suggests that a soft landing is highly unlikely to be engineered and that there is a significant likelihood of a recession in the not too distant future.
Indeed, high inflation and low unemployment are both good predictors of future recessions. In fact, since the 1950s, every time inflation has exceeded 4% and unemployment has been below 5%, the US economy has gone into recession within two years.
Today, inflation is at 8.5% and unemployment at 3.6%, suggesting that a recession will be very difficult to avoid.
behind the curve
Inflation is basically caused by too much money for too few goods.
In the short term, the supply of goods in the economy is more or less fixed – there is nothing that fiscal or monetary policy can do to change it – so the job of the Fed is to manage total demand in the economy so that it balances with the available supply.
When demand exceeds supply too much, the economy begins to overheat and prices rise sharply. According to our assessment, measures of overheating – such as strong demand growth, shrinking inventories and rising wages – have started to appear in the economy throughout 2021. But a new operating framework that the Fed passed in August 2020 prevented it from acting until it was backed. inflation was already evident.
As a result, the Fed is well behind the curve today in response to an overheated economy.
Sticking a soft landing is hard
To bring down runaway inflation, the Fed will now attempt 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. But that would risk causing major economic disruption and pushing the economy into a recession. It’s a soft landing: interest rates rise and demand falls enough to drive down inflation, but the economy continues to grow.
The engineering history of soft landings, however, is not encouraging. We found that whenever the Fed braked hard enough to bring inflation down significantly, the economy went into recession.
While some have argued that there have been several instances of soft landings over the past 60 years, including 1965, 1984 and 1994, we show in our analysis that those periods bore little resemblance to the present moment. .
In all three episodes, the Fed was operating in an economy with significantly higher unemployment, lower inflation, and weaker wage growth. In these historical examples, the Fed also raised interest rates well above the rate of inflation – unlike today, where inflation is 8.5% and interest rates are expected to remain lower. at 3% through 2023 – and explicitly acted early to prevent inflation from skyrocketing, rather than waiting until inflation was already excessive.
Why is the labor market relevant to inflation?
One of the reasons the Fed’s challenge is particularly tough today is that the labor market is unprecedentedly tight, meaning the demand for workers far exceeds the available supply. A tight labor market means companies need to raise wages to attract new workers.
Usually, the unemployment rate is used as an indicator of labor market tightness. Unemployment is very low today, and the Fed expects it to go even lower. But our research shows that the pressure to raise wages is even stronger than the unemployment rate suggests. The number of job vacancies has never been higher and workers are quitting at a record rate, two important factors in driving up wages.
In a sense, wages are the ultimate measure of underlying inflation – more than two-thirds of business costs go to labor – so rising wages put significant upward pressure on inflation. Wage growth is now at a historic rate of 6.6% and accelerating.
With wages rising so rapidly, there is little reason to hope inflation can slow to the Fed’s targeted 2% range. Our analysis shows that current wage growth implies sustained inflation above 5% and historically wage growth does not slow without a significant increase in unemployment and a recession.
The chances of a recession
The U.S. economy is now facing additional inflationary pressures from rising grain and energy prices due to the war in Ukraine and more supply chain disruptions as the COVID- 19 imposes new lockdowns in China. These factors threaten to further exacerbate inflation in the coming year.
In our assessment, the inflation problem facing the Fed today is significant and unlikely to be resolved without a significant economic slowdown.
Overall, the combination of an overheating economy, soaring wages, postponement of Fed policy and recent supply shocks means that a recession over the next two years is certainly more likely than not.
This article is republished from The Conversation under a Creative Commons license. Read the original article here: https://theconversation.com/fed-hopes-for-soft-landing-for-the-us-economy-but-history-suggests-it-wont-be-able-to-prevent – a-recession-182270.