Capital Markets

Whipping Inflation May Require Chancing a Recession

A more aggressive campaign to hike interest rates makes an economic downturn more likely.
Ted JacksonApril 6, 2022
Whipping Inflation May Require Chancing a Recession
Photo: Getty Images

In the ideal outcome for the U.S. economy, the Federal Reserve will fine-tune monetary policy just enough to bring down inflation but not too much that consumers stop buying and GDP growth stalls. That’s why raising interest rates without tipping the country into recession is called the “Goldilocks” scenario. 

In this scenario, everything for the Fed works out “just right”: the country gets dramatically lower inflation, strong employment, and no recession. And CFOs get to worry less about absorbing higher materials costs, squeezing more yield out of production lines, and driving away customers with transportation surcharges and higher product prices.

But is a so-called “soft landing” for the U.S. economy, during or after a campaign of interest rate increases, in the cards?

On Tuesday, San Francisco Federal Reserve Bank president Mary Daly predicted the economy could “teeter” from tighter monetary policy but it would avoid slipping into a recession.

The jobs market could probably withstand less monetary accommodation: the unemployment rate was 3.6% in March and businesses had 11 million unfilled positions. But the strength of the overall economy is a question. 

Last week, the Atlanta Fed GDPNow growth estimate for the just-finished first-quarter dropped to 0.9% from 1.5%. Economists at The Conference Board forecast real GDP growth was 1.7% in the first quarter and expect 1.3% growth in the second quarter (and about 3% for the year). In March, FOMC members had a similarly sanguine outlook — their median projection in March was GDP growth of 2.8% for 2022.

Said Fed Chair Jerome Powell on March 16, the day of the first interest rate hike: “The probability of a recession in the next year is not particularly elevated.”  

On Tuesday, San Francisco Federal Reserve Bank president Mary Daly predicted the economy could “teeter” from tighter monetary policy but it would avoid slipping into a recession.

In March, the Federal Open Market Committee projected it would raise interest rates six more times this year (25 basis points each at each meeting), reaching an upper bound of 2%. More hikes, possibly as many as five, would follow in 2023. That’s three more rate hikes than in the last tightening cycle, from 2015 to 2018, in roughly half the time. 

Since the March meeting, there have been some robust economic reports. Fed funds futures have shown a high probability of the Fed getting more aggressive early on — raising Fed funds by 50 basis points in May and June and pushing the benchmark rate range to 2.5%-2.75% by year-end. (See chart.)

Given the projections, Roberto Perli, director of global policy research at investment bank Piper Sandler, said the Fed’s Goldilocks expectations might turn out to be just that: a fairy tale. If the Fed Funds rate rises as enunciated, the rate will breach its “neutral” level, Perli said — the theoretical point where monetary policy is neither restrictive nor accommodative. 

The neutral rate is usually estimated at between 2% and 3%, but it’s hard to nail down. Perli’s research shows that nearly every time the Fed funds have tightened in the “vicinity of or above” the neutral rate, a recession has followed. 

Powell addressed the neutral rate issue in a speech to the Chicago Economic Club on March 21: “If we have to raise rates above neutral, then that’s what we’ll do.” In other words, if the Fed needs to risk a recession to beat back inflation, it will.

Not everyone is convinced the Fed will stick to its guns. Harvard Kennedy School professor and former Treasury Secretary Larry Summers thinks the Fed waited too long to start raising rates — he sounded the alarm all last year — and now deems it unlikely that the central bank will avoid a recession.

The chances of the Fed engineering a circumstance in which inflation recedes substantially and unemployment stays below 4% is “way, way odds off,” Summers told Politico. Indeed, Summers told Bloomberg TV that the FOMC would have to raise interest rates to 4% to 5% to return the economy to price stability.

Perhaps Andrew Ross Sorkin of the New York Times is right when he says that the Fed appears to be betting that inflation will solve itself. Or, at least, that its rate hikes will subdue inflation quickly (compared with how long it usually takes monetary policy to affect the real economy). The FOMC projects the personal consumption expenditures index will fall to the range of 2.4% to 3.0% in 2023. The last reading, for February, was 5.4%.

Sorkin points out, correctly, that the Fed foresees most of the drop will not be due to higher interest rates but instead to supply chain problems fading. That’s a debatable assumption as the war in Ukraine drags on and China is beset by an outbreak of COVID-19.

Said Vincent Reinhart, chief economist at BNY Mellon Asset Management: “While the Fed is no longer using the word ‘transitory’ for inflation, they still seem to be counting on it.”