Figures for US consumer price inflation in April will be released on Wednesday (11 May). They are expected to show the headline rate peaked in March. However, with inflation remaining at its highest levels for more than 30 years, investors are asking what it will take to bring it down.
Economists have certainly been caught out by the acceleration in prices having dismissed the pick-up as “transitory” when it started in early 2021. The rise in inflation is now looking more permanent and when questioned about whether it was still “transitory” the chair of the US Federal Reserve (Fed) Jerome Powell said “it is probably a good time to retire that word”.
So can the Fed can bring inflation down without causing a recession – i.e. deliver the so-called soft landing? Essentially the central bank has to restore the balance between supply and demand such that there is sufficient slack in the economy to ease wage and price pressures.
To achieve a soft landing this has to be done gradually with the growth rate slowing below trend rather than crashing into recession with output falling and unemployment rising rapidly.
Easier said than done
Past experience shows the recessions of the 1980s and 1990s followed a similar pick up in inflation to that being experienced today. While there was much talk of achieving a soft landing during these periods, this was not to be.
There are three reasons why the odds on a recession are high at present.
- Inflation is becoming entrenched. Inflation is high and broad based whilst the labour market is tight. The rise in sticky prices is a particular concern as by their nature they move more slowly and take longer to come down. This would allow more time for second round effects to develop where wages follow prices higher leading to a further round of price hikes. As a result the task for central banks of bringing price rises back to target is made harder: monetary policy needs to tighten by more to bring demand into line with supply. In this environment a recession may actually be necessary to bring inflation down.
- Monetary policy is a blunt tool. Milton Friedman’s theories have informed the monetary policies credited with taming inflation for most of the past four decades. He said, however, that monetary policy acts with long and variable lags. Confidence effects also play a role. Fears of recession can become self full filling for example, resulting in cut backs in spending. Central bank models give policymakers an indication of how long those lags are, but they are not precise. Judging how tight policy needs to be is difficult and the temptation is to keep raising rates until something breaks. This was very much the pattern in the 1980s and 1990s.
- Policy judgement is made more complex today by what is happening elsewhere.
- Monetary policy is tightening or set to tighten around the world in response to inflation, not just in the US. Global trade and external demand will be weaker as a result.
- Activity in Europe is significantly affected by the war in Ukraine and ongoing efforts to embargo Russian energy.
- The rise in commodity prices acts as a tax on consumption, reducing real incomes and spending around the world.
- China is not tightening monetary policy, but the zero Covid policy is hammering the economy.
- Fiscal policy is going into reverse after the massive support during the Covid lockdowns.
So the task of achieving a soft landing seems particularly challenging at present. Interest rates will still rise as they are starting from low levels – below the “equilibrium” rate.
When an economy is at full capacity this is the rate required in order to avoid either overstimulation (and possibly undue inflationary pressures) or under-stimulation (possibly resulting in economic contraction and the risk of deflation).
We are looking for a further five consecutive hikes in rates with the fed funds rate peaking at 2.5 – 2.75% at year end. Some would see this rate as being consistent with a neutral central bank policy.
Given the current headwinds, however, it could end up being tight enough to cause the economy in the US to roll over. Inflation will come under control, but the price could well be a recession.
Further reading : How US inflation became entrenched in the system, by Keith Wade, Chief Economist & Strategist at Schroders.