From this perspective, the Fed’s projected soft landing where growth slows to just below 2% and inflation falls below 3% in 2023 looks like wishful thinking.
However, before we dismiss the Fed’s forecasts completely, we need to dig deeper into the current high CPI inflation rate. Are there reasons to believe that inflation may come down more easily, i.e. with less output loss or a smaller increase in unemployment?
To start, commodity prices have played a significant role in boosting inflation. If we strip these out, then inflation on the Fed’s preferred measure (the core PCE deflator) is running at 5.2%. It would seem that a fall in inflation back to 2% from here would be less onerous. However, the sensitivity of core PCE inflation to changes in GDP is also lower. For example, in the two major recessions cited earlier the impact of GDP on inflation is more than halved, so we would still need a 3 pp fall in GDP to generate a fall in core inflation of just over 2%.
Nonetheless, that would still bring inflation closer to target. Would such a downturn in the US also lead to lower commodity prices, helping to drive headline inflation down further? In the past a US recession could be expected to trigger just such a fall as global demand weakens, but today the outcome would be very dependent on how the world economy adjusts to the potential loss of Russian supply. It is possible that shortages keep oil (and commodity prices in general) elevated, even with a US recession.
So far it looks as though a significant slowdown in GDP will be needed to hit the Fed’s inflation goals. However, our historical comparison does not capture the structural changes in the world economy over the past 60 years. In particular the success in keeping inflation low and stable for a considerable period of time means that inflation expectations remain well anchored.
One of the reasons inflation proved so stubborn during the 1970s and early 80s was the pick-up in wages which followed the initial spike in inflation. Subsequent second round effects kept inflation high as wages and costs rose. To a large extent this reflected a lack of belief in the ability of the authorities to bring inflation down.
Chart 3 shows that inflation expectations (both short and medium term) were elevated in the late 1970s and when combined with strong trade unions and labour bargaining power, it was not surprising that pay accelerated and the economy entered a wage price spiral. Consequently, unemployment had to rise significantly to bring wage growth down.
Today the picture is different, although short-run inflation expectations and wage growth have picked up with the tight labour market, medium-term price expectations remain stable. Short-run expectations, which tend to be sensitive to the price of gasoline, have risen, but over five years households expect inflation to be close to target. If sustained, this bodes well for the labour market adjustment; unemployment need not rise as much if wage growth is contained.
Greater central bank credibility and possibly lower commodity prices could help bring inflation down faster than in the past and at less cost in terms of output and employment. However, the fundamental problem remains: the US economy and much of the world is late cycle and overheating.
Monetary policy is a pretty blunt instrument in these circumstances, with central banks being forced to tighten until unemployment rises and sufficient slack is created. In our view, this would point to a fall in GDP of around 2% from peak to trough, less than in the Great Recession or Volcker era, but still significant and more than the current consensus of economists.
Fed should take a leaf out of the Bank of England’s book and forget the soft landing
To achieve this the Fed will have to tighten further and take interest rates above their current view of neutral. Rates will be higher for longer, but that does not mean tightening relentlessly until unemployment is 6 or 7%, for example. The lags from higher rates to the economy mean that the Fed should proceed cautiously as the full impact is not felt for many months later. In this respect there is scope for a Fed pivot toward the end of next year, with rates likely to be easing as the economy falls into recession.
Although the Fed’s options are limited, it could take a leaf out of the Bank of England’s (BoE) book. The BoE has taken considerable flack for forecasting a significant recession in the UK with inflation only moving slowly toward target. However, no one could argue that they have not warned people, giving households and businesses a signal to what is ahead.
In this respect it would be helpful if chair Powell and the Fed stopped projecting a US soft landing. A look back at history shows that such forecasts only give false hope and create a further misallocation of resources. Politically this is difficult, but the earlier households and firms can start to make the inevitable adjustments the better.