Events in the US economy have played out Federal Reserve fashion, where price pressures have peaked despite sustained economic growth and strong payroll gains. But don’t be fooled: the task of getting inflation back to the Fed’s 2% target remains extremely daunting, both in practical and political terms.
Economic indicators – such as the June employment report, industrial production and activity indexes from the Institute for Supply Management (ISM) – suggest that growth has slowed, but that the economy is not in recession
Meanwhile, energy prices have fallen, core inflation is slowing, wage inflation may be declining, and longer-term inflation expectations remain well-anchored. To some, this might seem like the beginning of a soft landing and a possible triumph for the Federal Reserve.
But it is far from it. First of all, the fed it has not made much headway in curbing excessive demand for workers. Despite months of strong job growth, the ratio of the number of job openings to the number of unemployed workers remains at 1.9, almost double the level that Fed Chairman Jerome Powell considers desirable.
so that the inflation back to 2%, the central bank will have to significantly increase the unemployment rate from the current 3.6%. Even a 0.5 percentage point rise is likely to imply a recession, because that is what has always happened in the past when the unemployment rate has passed that threshold.
Second, the fed it must be sure that it has succeeded in driving down inflation in a sustainable way. Powell correctly understands that the costs of missing the 2% target over the next year or two outweigh the costs of a mild recession, because missing it would cause inflation expectations to rise, necessitating even tighter monetary policy. adjusted and would trigger a subsequent sharper recession.
In the late 1960s and through the 1970s, the central bank tightened its monetary policy enough to bring inflation down at times, but reversed course too soon. As a result, the highs and lows of inflation continued to rise, until the 1980s, when Paul Volcker had to force a deep recession to regain control.
Against this background, officials will hesitate to stop tightening monetary policy until they are very confident (greater than 80% chance) that they have done enough, that the labor market has enough room to keep inflation low and stable, and that the easing of financial conditions will not lead to an uptick in inflation.
Third, the adjustment will generate political complications for the fed. In addition to the problems of job losses and economic contraction, higher interest rates will cause operating losses for the Federal Reserve, as the interest it pays on bank reserves far exceeds the return on its holdings of Treasury securities. and mortgages.
The central bank’s own estimates suggest it will start losing money in the fourth quarter of this year and post big losses in 2023 if interest rates move anywhere near what the bank and markets expect. The losses of the fedwhich will come at the expense of taxpayers, could embolden critics of quantitative easing to argue that the Fed has violated the boundary between monetary policy and fiscal policy.
Congress could even try to kill the tool, hurting the Fed’s ability to provide more monetary stimulus the next time short-term interest rates hit the lower bound of zero.
Beyond that, operating losses could cause the fed is reluctant to sell mortgage-backed securities, despite its commitment to eventually return to a portfolio of all Treasuries. Such sales would result in losses on the securities, the price of which has fallen significantly as interest rates have risen.
Altogether, the fed it still has a long and extraordinarily difficult way to go.