Why the Federal Reserve won’t rush to relax its fight against inflation

Jerome Powell, Chairman of the US Federal Reserve, speaks during a Fed Listens event in Washington, DC, USA, on Friday, September 23, 2022. This week, Federal Reserve officials gave their signal clearest so far that they are willing to tolerate a recession as the necessary trade-off to regain control of inflation.

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Think of Federal Reserve Chairman Jerome Powell as a gymnast who sprints across the mat, spirals, spins, spins, then spins in the air and tries to make sure he still lands perfectly on his feet.

That is monetary policy in this era of rapid inflation, slumping economic growth and rising fears about what could go wrong. Powell it’s that gymnast, standing on the cheap version of an Olympic mat, and having to make sure everything goes smoothly.

Because if things go wrong, they can go very wrong.

“They have to keep the landing,” said Joseph Brusuelas, chief US economist at RSM. “It’s the bottom end of the economic ladder that will bear the brunt if the Fed doesn’t hold the landing properly. They lose jobs and their expenses go down and they have to dip into savings and 401(k)s to make ends meet.”

Consumers pressured by constantly rising prices they are already tapping into the savings to cover costs.

The personal savings rate was just 3.5% in August, according to the Office of Economic Analysis. That was just above a 3% rate in June, the lowest in 14 years, dating back to the early days of the financial crisis.

The prices of everyday items have risen at an extraordinary rate. Eggs were up 40% from a year earlier in August, butter and margarine soared nearly 30% and gasoline, even down 10.6% for the month, was still more than 25% above average. same point in 2021.

The consequences of not getting that under control could be dire, just as they could be if the Fed goes too far in its quest to restore price stability to the US economy.

Brusuelas said the worst case scenario would be something like a 5.5% unemployment rate and the loss of 3.5 million jobs, as companies have to lay off workers to cope with the economic slowdown and rising costs that would occur if inflation were unchecked.

The risk of failure

As it stands, the economy is very likely headed for a recession anyway. The question is how much worse it can end.

“It is not a question of whether or not we are going to enter a recession, it is when we are going to have it and the degree of intensity of the recession,” Brusuelas said. “My feeling is that we are in a recession by the second quarter of 2023.”

The Fed can’t just keep raising rates while the economy weakens. It must walk until it reaches an equilibrium where it slows the economy enough to correct the multifaceted mismatches between supply and demand, but not so much as to cause deeper and unnecessary pain. According to the Latest Fed Outlookpolicymakers expect to continue through 2023, with benchmark rates around 1.5 percentage points from the current level.

“If the Fed overdoes it, you will have a much deeper recession with higher unemployment,” Brusuelas said.

That the Fed is going too far and suffocating the economy too much is the main fear of critics of the central bank.

They say there are tangible signs that the 3 percentage points of rate hikes so far in 2022 they have achieved their goal, and the Fed can now pause to allow inflation to recede and the economy to recover, albeit slowly.

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“The Fed could resign today and inflation will return to acceptable levels next spring,” said James Paulsen, chief investment strategist at The Leuthold Group. “I really think the war on inflation has been won. We just don’t know.”

Paulsen looks at things like falling commodity prices, used cars, and imported goods. He also said prices for tech-related items are falling while retail inventories are rising.

In the labor market, he said that the balance of payroll growth this year it has come from the supply side of the economy that the Fed wants to stimulate, rather than the demand side that fueled the explosion in inflation.

“If they want, they can cause an unnecessary recession,” Paulsen said. “I just don’t know why they want to do that.”

Paulsen is not alone in his criticism. Calls are spreading on Wall Street for the central bank to ease its policy tightening and watch how the economy progresses from here.

Wells Fargo chief equity strategist Christopher Harvey said the message from the Fed, particularly from Chairman Jerome Powell, that it is willing to inflict “some pain” on the economy it is being interpreted as the central bank willing to go ahead “until something breaks”.

“What is concerning is the apparent downplaying of capital market signals as the Fed moves toward its 2% inflation target,” Harvey said in a note to clients. “So those signals will need to get stronger (i.e. even lower stocks and wider spreads) before the Fed reacts. This also implies that the recession will likely be longer/more severe than fundamentals indicate.” current and market risk.

human costs

None other than the United Nations issued an agency report on Monday in which the UN Conference on Trade and Development warned of the ramifications that rate hikes could have globally.

“The current course of action is hurting vulnerable people everywhere, especially in developing countries. We must change course,” UNCTAD Secretary-General Rebeca Grynspan told a news conference in Geneva, according to a Reuters account.

However, the data suggests that the Fed still has work to do.

The next Consumer Price Index report is expected to show that the cost of living continued to rise in September. the Cleveland Fed Nowcast Tracker of items in the broad-based basket of goods and services used by the Bureau of Labor Statistics to calculate the CPI shows another 0.5% increase, excluding food and energy, representing a 6.6% year-on-year pace. Including food and energy, the headline CPI is forecast to rise by 0.3% and 8.2%, respectively.

While critics argue that those kinds of data points look backwards, the Fed faces an additional optical problem after it downplayed inflation when it started rising significantly more than a year ago and was slow to act.

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That puts the burden back on politicians to keep tightening to avoid a scenario like the one in the 1970s and early 1980s, when then-President Paul Volcker had to drag the economy into a harsh recession to stop inflation once and for all. for all.

“This is not the 1970s by any stretch of the imagination, for many reasons,” said Steve Blitz, chief economist at TS Lombard. “But I would say they are still overly optimistic that the rate of inflation will slow down on its own.”

For their part, Fed officials have stuck to the company line that they are willing to do whatever it takes to stop price increases.

San Francisco Fed President Mary Daly spoke emphatically about the human consequences of inflation, telling an audience Tuesday that she has been hearing about it from her constituents.

“Right now, the pain that I hear, the suffering that people are telling me about what they are going through, is on the side of inflation,” he said. during a talk at the Council on Foreign Relations. “They are worried about their daily lives.”

Addressing wages specifically, Daly said one person told him, “I’m running fast and I’m falling behind every day. I’m working as hard as I can and I’m falling further behind.”

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