Fed’s ‘soft landing’ clock may be ticking
Fed's 'soft landing' clock may be ticking
The Fed’s Delicate Dance: Navigating Inflation and Interest Rates
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The Federal Reserve’s primary objective has always been to maintain control over inflation, using the benchmark overnight interest rate as a tool. However, the challenge lies not only in raising rates to curb inflation but also in determining when and how to cut rates to relieve the pressure on individuals and businesses. Achieving a “soft landing,” where inflation falls without causing a recession or significant job losses, is no easy feat.
Looking back at previous recessions, such as those in 1990-1991, 2001, and 2007-2009, we see that the Federal Reserve reached its peak rate level months before the start of the downturn. This highlights the difficulty of reversing a slide once it begins and the challenge of aligning the slow-moving effects of monetary policy with the future needs of the economy.
The cardinal sin of central banking is allowing high inflation to become embedded in the economy. Fed officials would rather risk going too far to control inflation than stopping short and risking its resurgence. Antulio Bomfim, head of global macro at Northern Trust Asset Management, explains, “We all wish we could slow the economy ‘just enough.’ The margin of error is quite high… The risks of doing too little – that asymmetry – is still there.”
This implies that there may be at least one more rate hike on the horizon, despite investor expectations that the Fed is finished. Rate futures markets currently reflect only a roughly one-in-four chance of another increase. Nevertheless, the Fed remains committed to exerting control over inflation and maintaining a cautious approach.
Assessing the ‘Puzzle’ Pieces
Recent data on wages, growth, and prices contribute to the dilemma facing policymakers as they strategize further interest rate hikes and determine how long rates should remain elevated. These decisions will have significant consequences for the direction of the economy in 2024, a presidential election year.
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Despite sixteen months of rapid monetary tightening, the economy surprisingly grew at a faster-than-expected 2.4% annualized rate in the second quarter. Employment compensation costs also rose by 4.5% for the 12-month period ending in June, indicating persistently elevated inflationary pressures.
Although headline inflation has dropped from its peak in 2022, underlying price pressures have receded at a slower pace. The personal consumption expenditures price index, excluding food and energy costs, slowed notably in June to 4.1% year-over-year but remains well above the Fed’s 2% target.
Fed Chair Jerome Powell acknowledges that the components necessary for low inflation may be falling into place, but he remains cautious. Powell stated, “We need to see that inflation is durably down… Core inflation is still pretty elevated. We think we need to stay on task, hold policy at restrictive levels, and be prepared to raise further.”
The delicate balance lies in vanquishing inflation without stifling economic activity unnecessarily or losing ground when a downturn occurs. Powell explains the timing required for rate adjustments, emphasizing that changes in the Fed’s benchmark rate can take time to impact the economy. This slow process affects interest rates charged to consumers for credit cards, auto loans, mortgages, and business loans.
The Quest for Compatibility
Powell remains noncommittal about when the Fed will consider cutting rates, only stating they will do so when they are comfortable. He maintains that inflation will not return to target levels until the economy experiences a sustained period of slowing, potentially impacting employment figures.
Evidence suggests that the employment market is beginning to cool from the labor shortages and substantial wage increases experienced during the pandemic years. Despite the low unemployment rate, workers are quitting less frequently, job openings have decreased, and wage increases have slowed.
However, some experts question whether Powell’s focus on economic “slack” to complete the task mirrors the mistakes of previous Fed chairs, potentially setting the stage for an unnecessary recession. Lindsay Owens, executive director of Groundwork Collaborative, suggests that exploring the compatibility of low unemployment and low inflation should be the guiding principle. She proposes testing the limits of these seemingly contrasting factors.
While the latest Fed projections indicate a decline in rates by the end of 2024, the decline is less than the anticipated drop in inflation. Consequently, the inflation-adjusted interest rate continues to rise. The risk of maintaining restrictive policies for too long is the potential collapse of the economy—a scenario previously observed in historical recessions.
Thomas Simons, senior U.S. economist at Jefferies, warns that the economy may be approaching its “last-gasp” phase. Indications such as slower bank lending, rising credit costs, and increased loan delinquencies align with patterns observed at the start of previous recessions since 1980. However, he notes that the Fed is likely to be cautious in its rate cuts, waiting for weakened conditions to manifest before acting decisively.
Conclusion
Balancing inflation, interest rates, and economic growth is a complex task for the Federal Reserve. Recognizing the risks of both inflation and recession, policymakers must carefully consider when to raise or cut rates. The challenge lies in finding the delicate equilibrium that allows for controlled inflation while promoting economic stability. The decisions made in the coming months will have far-reaching effects on the U.S. economy, potentially shaping the trajectory leading up to the 2024 presidential election.
