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As inflation continues to cool—even troublesome shelter inflation– the US Federal Reserve is facing increased pressure to start cutting the benchmark interest rate affecting everything from mortgages to credit cards. The central bank has spent much of the past two years raising that rate in an effort to cool price rises.
After the covid-19 pandemic triggered a brief recession, many things happened at once. Purses were fat not only from government aid, but also because their owners did not have to spend money to go outside. Wages rose as people used the post-vaccination boom as a chance to get better jobs or unionize the ones they already had. So-called “revenge” spending increased, find its expression in a maximalist way, for example. Supply chains that had become depleted when all the factories and shipping channels closed suddenly came alive again, and businesses of all kinds were rushing to get back up to speed.
All these factors have come together to push prices higher, with US inflation reaching nearly 9% in June 2022, a level not seen in 40 years.
The Fed’s dual mandate, as always, is to bring prices back down to earth, while making sure too many workers don’t lose their jobs in the process. Because the rush of people back into the labor market has kept unemployment at the near-record lows it approached before the pandemic, Fed Chairman Jay Powell has trained his sights only on fighting inflation.
The big problem with monetary policy is that it is an incredibly broad solution to what can be a set of very narrow problems. Powell warned that economic pain was likely to follow the rate hikes, noting that the path back to price stability was “will probably be bumpy and take time.”
Would people lose their jobs? Probably. Would a recession occur? Can be. But this has been accepted as the cost of maintaining order in the world’s largest economy. Still, Powell hoped he could achieve the central banker’s Holy Grail: a soft landing.
The Landing Hardness Scale
To explain a “soft” landing, it helps to know what a “hard” landing looks like. Back in the 1970s, inflation skyrocketed after the shock of the OPEC oil embargo. The Federal Reserve responded walking through interest rates to mouth-watering levels north of 12%. (Today rates are at 5.5%.) Although inflation did fall, the US also suffered its longest downturn since the Great Depression until the Great Recession of 2008. Unemployment rose to 9%.
In contrast, a “soft” landing leaves price increases back to the Fed’s preferred range of 2% without also seeing unemployment increase by too much. It’s happened before, as in 1984 and 1994, which is why then-Fed Chairman Alan Greenspan is considered such a hero by some financial history buffs. And since the Fed stopped raising rates in Septemberinvestors began to think that Powell had also achieved a soft landing.
After Wednesday’s Federal Reserve meeting on December 13, where the central bank did not cut interest rates, but for the third month in a row did not raise them eitherthe “dot plot” charting individual Fed governors’ forecasts for rates and economic growth suggested that rate slices may come as soon as next year. It was the first time since 2020’s early pandemic cuts that the Fed telegraphed easier monetary policy.
Wall Street went bananas. Interest rates on 10-year Treasury notes, where the lower the number the better the price, are back below 4% and trending downward for the first time in years. Stocks hit record highs.
“After being given a thumb, market participants, as they often do, took a mile,” wrote economist Jonas Goltermann in a note for research firm Capital Economics. The market got so frothy that John Williams, head of the New York Fed branch, had to go on CNBC and tell everyone to simmer down.
“We’re not really talking about interest rate cuts right now,” Williams said. “We’re very focused on the question before us, which, as Chairman Powell said, is, ‘Have we brought monetary policy to a sufficiently restrictive stance to ensure that inflation gets back to 2 percent?’
It is true. Personal consumption spending, the inflation gauge the Fed pay particular attention to because it tracks the prices people actually pay for things instead of those offered to them, is still a full percentage point above where the central bank wants it. “Core” inflation, which takes out energy and food prices, is even further out.
Monetary policy timing is a delicate dance. Keep rates too high for too long, and economic growth becomes more difficult than it needs to be. Cut them too soon, and inflation starts creeping back. Ten years ago, Wall Street freaked out when the Fed announced earlier than expected that it would begin to slow—not even stop—its stimulus purchase of assets.
The so-called “Taper Tantrum” assets of all kinds fell into a tailspin, putting a damper on the 2008-09 recovery financial crisis. So even if the Fed doesn’t want to be bossed around by markets, sometimes it has to play ball.
“We are aware of the risk that we will go on too long,” Powell said Wednesday in response to a question from Bloomberg’s Michael McKee about timing. “We know that’s a risk, and we’re very focused on not making that mistake.”
