The Fed is inching closer to an outcome that staff economists saw as unlikely just six months ago: returning inflation to a normal range without sending the economy into recession. It seems there is.
A lot can still go wrong. However, inflation has fallen markedly in recent months, running at an annual rate of 3.1%, down from a peak of 9.1% in 2022. At the same time, growth is strong, consumers are spending and employers are continuing to hire.
This combination was a surprise to economists. Many expected a red-hot job market to cool down, with far more job openings than available workers. It must be painful process. Instead, workers returned from the sidelines of the labor market to fill the vacancies, supporting a relatively painless rebalancing. At the same time, supply chain recovery has increased inventories and alleviated shortages. Prices have stopped pushing up inflation and are actually starting to push it down.
The Fed expects “a continuation of what we’ve seen in the past: improved labor market balance without a significant increase in the unemployment rate, lower inflation without a significant increase in the unemployment rate, and a significant increase in the unemployment rate.” “We expect growth to slow, without increasing,” Fed Chairman Jerome H. Powell said Wednesday.
Fed policymakers are looking ahead to 2024 and are aiming squarely at a soft landing. Officials are trying to assess how long interest rates need to remain high to ensure inflation is controlled without bringing economic growth to an unnecessarily painful halt. The strategy is likely to be delicate, which is why Mr. Powell has been careful not to declare victory prematurely.
But policymakers clearly see it coming into view, based on economic projections. The Fed chair suggested Wednesday that interest rates are unlikely to rise to 5.5% from the set 5.25% unless inflation shows a surprising recovery, and central bankers said they expect inflation to continue to decline We expect three rate cuts by the end of 2024 as unemployment increases only slightly.
If they can make that landing, Mr. Powell and his colleagues will have achieved a major feat in American central banking. Fed officials have historically pushed the economy into recession when trying to contain high levels of inflation, such as the one reached in 2022. faced criticism Such successes would define his legacy, as he could not have predicted how persistent and severe inflation would become.
“The Fed looks pretty good right now in terms of how things are going,” said Michael Geipen, head of U.S. economics at Bank of America.
Respondents to a regular survey of market participants conducted by research firm MacroPolicy Perspectives are more optimistic than ever about the possibility of a soft landing, with 74% saying they want inflation to reach the Fed’s December target. They answered that there was no need for a recession to bring the economy down. The survey from the 1st to 7th showed an increase from a low of 41% in September 2022.
Fed staff I started to anticipate The recession was caused by the failure of several banks earlier this year. I stopped predicting One in July.
People were pessimistic about the prospects for a slow downturn, in part because they believed the Fed had been slow to respond to rapid inflation. Throughout 2021, Powell and his colleagues argued that even some prominent investors argued that higher prices were likely to be “temporary.” macroeconomist He warned that it could continue.
These warnings proved to be prescient, and the Fed was forced to make a major change in policy. Inflation has now exceeded 2% for 33 consecutive months.
When central banks began raising interest rates in response, they did so rapidly, rising from near zero in early 2022 to the current range of 5.25% to 5.5% in July of this year. Many economists feared that slamming the brakes on the economy would cause whiplash in the form of a recession.
However, the temporary calls now look somewhat improved. “Temporary” just took a long time to run.
Much of the reason inflation has eased can be attributed to a recovery in supply chains, easing of shortages in key goods such as cars, and a return to pre-pandemic spending trends, with households buying a variety of goods and services instead. To do. Just the luxuries you keep at home, like your couch and exercise equipment.
In other words, the pandemic problems that the Fed had expected to be temporary have actually disappeared. It took years instead of months.
“As a charter member of the interim team, it has taken much longer than many of us expected,” said former Fed Vice Chairman Richard Clarida, who served as Fed vice chairman until early 2022. However, he noted that the situation is adjusting.
“The Fed deserves some credit for the economic slowdown,” he said, because the Fed’s policies have served to dampen demand and prevent consumers from adjusting their future inflation expectations.
Rising interest rates didn’t fix supply chains or convince consumers to stop buying sweatpants in bulk, but they did help cool some key purchase markets like homes and cars. Without these higher borrowing costs, the economy might have grown even more strongly, giving companies more room to raise prices more significantly.
The question now is whether inflation will continue to slow even as the economy continues to perform well, or whether a more pronounced economic slowdown will be needed to continue to push the economy down. The Fed itself expects growth to slow significantly next year to 1.4% from 2.6% this year, based on new forecasts.
“Certainly they’ve done very well, better than we expected,” said William English, a former senior Fed economist and current professor at Yale University. “The question remains: Without more room in the labor and goods markets, will inflation return to 2%?”
So far, there are few signs of cracks in the job market. Employment and wage growth slowed, but the unemployment rate remained at a historic low of 3.7% in November. Consumers continue to spend, and growth in the third quarter was unexpectedly high.
While these are positive developments, there remains the possibility that the economy may be a bit too stimulated to completely cool down inflation, especially in the key services sector.
“We don’t know how long it will take to get to the last mile of inflation,” said Karen Dynan, a former Treasury Department chief economist who teaches at Harvard University.
With that in mind, next year’s policy-making could become more art than science. If growth is slowing and inflation is falling, cutting interest rates would be a very obvious choice. But what happens when growth is high? What happens when inflation stalls and growth collapses?
Powell acknowledged some of that uncertainty this week.
“Inflation continues to decline and the labor market continues to rebalance,” he said. “It’s been very good so far. I expect it to get more difficult from here, but so far it hasn’t.”
Mr. Powell, who trained as a lawyer and spent most of his career in private equity, is not an economist and has sometimes expressed caution about using major economic models and guidelines too religiously. . Bank of America’s Gappen said his lack of commitment to the model could come in handy next year.
This leaves the Fed chief and the agency he leads as they respond to an economy that is devilishly difficult to predict, as past experience with the pandemic has proven to be a poor precedent. We may be able to respond more flexibly.
“In the age of COVID-19, we may have been right to have someone who is skeptical of frameworks manage the ship,” Gapen said.