Fed set to hike rates as ‘soft landing’ becomes tougher sell

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Federal Reserve officials are meeting this week with one major goal in mind: to cool the economy enough to slow rapid inflation.

The chances of achieving this without plunging the country into a recession are dwindling.

As the Fed prepares to take an aggressive stance to rein in persistent inflation — likely discussing a three-quarter point interest rate hike on Wednesday — investors, consumers and economists increasingly expect more to the economy tipping into a slowdown next year. Even researchers who think the central bank can still pull off a “soft landing,” in which policymakers steer the economy onto a more sustainable path without causing unemployment to spike and outright contraction, recognize that the path to this optimistic result has become more narrow.

“It wasn’t obvious that a soft landing was feasible,” said Michael Feroli, chief US economist at JP Morgan, who still thinks it could happen. “The degree of difficulty has probably increased.”

The problem comes from inflation data in the United States, which is becoming increasingly worrying. Consumer prices accelerated in May to an 8.6% pace, the fastest since 1981. Even after the removal of volatile food and fuel prices, there is little the central bank can do to control, inflation was firmer than expected last month, rents, air fares and hotel room rates jumped. To compound the problem, according to two recent reports, inflation expectations are on the rise.

The data suggests that the Fed may need to act more decisively, slowing consumer and business spending and the labor market even further, to bring prices under control.

Ahead of last week’s inflation report, central bankers were expected to raise interest rates by half a percentage point this week and then again in July. But now the Fed is likely to be discussing faster action to try to eliminate inflationary pressures before they become a permanent feature of the economic backdrop. It could also continue to raise rates by more than the usual quarter-point increases through September or even beyond, many economists predict.

The Fed has already raised rates twice this year, by a quarter point in March and half a point in May. If he takes more drastic measures – making mortgages and business loans even more expensive, stifling business expansion plans and stifling the job market – it would make higher unemployment and a shrinking economy more likely. .

For months, the Fed has acknowledged that the path to slower inflation is likely to be unpleasant. When the central bank raises the fed funds rate, it seeps into the economy to dampen consumer and business demand, which ultimately depresses wages and prices. The way to get inflation under control is, essentially, to cause some harm to the economy.

Still, top policymakers have expressed consistent optimism that with the US labor market starting from a strong position, it may be possible to cool inflation without erasing recent labor market progress. With so many job vacancies per unemployed person, logic suggests, it might be possible to restrict conditions just enough to better balance the supply of workers with the demands of employers.

“I think we have a good chance of having a soft or soft landing,” Fed Chairman Jerome H. Powell said at his press conference after the central bank’s May meeting. He added that “the economy is strong and well placed to manage tighter monetary policy.”

But someone has to feel the pressure and stop spending for Fed policy to work – and with higher and more stubborn inflation, it will take greater pressure on demand to bring it into line.

In fact, said JP Morgan’s Feroli, the Fed’s economic projections – which will be released for the first time since March after this meeting – could show a marked slowdown in growth and a rise in the unemployment rate to illustrate that policy makers are serious. on controlling the economy and controlling prices. Unemployment is now at 3.6%, which is below the 4% level that Fed officials believe a healthy economy can sustain over the long term.

If the Fed is to significantly slow the economy, it will be a challenge to do so without causing a recession. For one thing, when unemployment skyrockets, recession tends to follow. Downturns occurred when the unemployment rate rose 0.5 percentage points from its recent low on average over a three-month period – a relationship called the Sahm rule, according to economist Claudia Sahm.

On the other hand, interest rates are a blunt tool and work with a lag, and the Fed can simply overdo it.

Investors fear a bad result. Shares plunged into a bear market on Monday – meaning they quickly fell 20% – as investors fret that the central bank is about to trigger a recession in its quest to rein in the global economy. ‘inflation.

“People think the soft landing is a dream,” said Priya Misra, head of global rates strategy at TD Securities. “That’s the big picture.”

It’s not just Wall Street that is increasingly gloomy. Consumer confidence fell to its lowest level on record in preliminary data from the University of Michigan survey, and expectations of rising unemployment in a New York Fed survey have picked up.

Even if the Fed is also becoming more uncertain about its chances of gently slowing the economy, Mr. Powell may not be saying so. Coming from a senior central bank official, a prediction that the economy is heading for tough times could become a self-fulfilling prophecy, shattering already fragile confidence.

“They went from mild to mild – I don’t think there’s another term they can use to say ‘not a complete disaster,'” Ms Misra said. “I think the markets are calling their bluff, that they won’t be able to pull it off.”

A recession would spell trouble for the White House. President Biden has been quick to stress that the Fed is independent and that he will respect its ability to do what it deems necessary to bring inflation under control, even as its approval ratings crack and the economy is heading for a potentially difficult period of transition.

“The Federal Reserve has the primary responsibility for controlling inflation,” Biden wrote in a recent opinion column. He added that “past presidents sought to influence his decisions inappropriately during times of high inflation. I will not do that.

Even so, some have argued that the central bank shouldn’t be the only game in town when it comes to controlling inflation, given the pain its policies inflict. Skanda Amarnath, executive director of the employment advocacy group Employ America, argued that the White House should take more aggressive action to improve gas supplies, for example, to try to offset inflationary pressures.

Trying to stifle them by reducing demand — which the Fed can do — comes at too high a cost, he argued.

“If you rely exclusively on the Fed to fix this problem, the outlook is not good,” he said.

But most mainstream economists view the Fed as the key solution to inflation, just as it was when Paul Volcker led it in the 1980s. He raised interest rates to punitive, inflation-promoting levels. recession to drive down prices that had soared during the 1970s. That’s why many are expecting a big move on Wednesday.

A three-quarter point move “would underscore their commitment to avoiding the mistakes of the 1970s,” said Diane Swonk, chief economist at Grant Thornton. “They are now trying to bring inflation down and keep it going in a more inflation-prone world.”

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