Will the Fed cause a recession by raising rates? Here’s what experts are saying
Sun., May 1, 2022
High inflation comes with a heavy economic price, but so can the Federal Reserve’s attempts to get it under control.
The Fed has a tried-and-true method for curing inflation: raising interest rates. But it’s a blunt instrument, with no room to fine-tune specific corners of the economy. Increasing borrowing costs is only successful because it slows demand across the board – and along with it, the economy and likely hiring, experts say. That’s despite U.S. central bankers projecting 10 rate hikes by 2023 yet unemployment holding at a half-century low, according to their latest economic projections.
“They’re trying to slow down the overall economy, and that would include firms’ appetite to hire, without ever saying that out loud,” said Luke Tilley, chief economist at Wilmington Trust.
Whether or not the Fed causes a recession is debatable, economists say. But the Fed’s actions will have consequences – it’s just a matter to what degree.
Few can argue that the financial system still needs access to the punchbowl at a time when consumer price gains in March hit another 40-year high of 8.5%. Fed Chair Jerome Powell himself said the economy is strong enough to withstand tighter monetary policy, and policymakers are betting that they can let some air out of the balloon without completely popping it.
“No one expects that bringing about a soft landing will be straightforward in the current context,” Powell said in a March 21 speech. “My colleagues and I will do our very best to succeed in this challenging task.”
Such is the sacrifice always at the heart of central banking, but it is this dilemma that could hurt U.S. consumers’ wallets. By many standards, the labor market is even tighter than it was before the pandemic and companies have had a record number of job openings for 13 months, giving jobseekers the rare bargaining power to negotiate for higher pay and more flexibility.
“Even if we don’t cause a recession, there’s going to be pain that we create. That is a reality,” said Marc Goldwein, senior vice president and senior policy director for the Committee for a Responsible Federal Budget. “But inflation is too painful. You can’t juice the economy forever and expect that it’s sustainable. You have to rip off the Band-Aid before it gets even worse.”
It’s also been nightmare fuel for markets, consumers and economists alike. Confidence in the U.S. economy has fallen to an 11-year low, the S&P 500 has dropped nearly 8% since 2022 began, and one of investors’ favorite recession indicators – the 10-year, 2-year Treasury yield curve – inverted for the first time since 2019.
Part of the fear is the Fed’s track record. Eight of the Fed’s past nine tightening cycles have ended in a recession, according to an analysis from Roberto Perli, head of global policy at Piper Sandler. Officials can struggle to see the runway when they attempt to land the plane because it takes time to tell just how much each rate hike is influencing the economy.
That also makes it increasingly difficult for central bankers to avoid overdoing it. Experts in Bankrate’s First-Quarter Economic Indicator survey put the chance of a recession in the next 12-18 months at 1 in 3 thanks to the Fed’s likely rapid tightening. Officials are starting to rally behind a supersized, half-point hike for May – the first since 2005 – and more could follow.
Rates might have to rise above 2.5% to get inflation down
Policymakers also have blind spots because it’s hard to tell just how high they should take interest rates.
A crucial factor will be assessing the point at which interest rates are tapping the brakes on the financial system, rather than just gradually letting up on the accelerator.
Policymakers in their latest projections from March 2022 said that a so-called “neutral rate of interest” could be 2% to 3%, with their median estimate pinning it at 2.5%. Rates rising above that level – which could happen by December, according to both market participants and key Fed officials – would mean the Fed is no longer providing the financial system with any juice.
Yet, inflation in March was more than three times higher, and investors also see elevated inflation lasting for at least five more years, according to one key expectations gauge. Those shifts have led some experts to question whether rates will have to go even higher before successfully getting inflation down.
“The Fed is tightening, but it’s tightening from unbelievably accommodative financial conditions,” said Megan Greene, senior fellow at Harvard Kennedy School. “That also means that, even though the Fed is tightening aggressively, it has a ways to go before it really chokes off growth.”
But don’t expect a return to the double-digit interest rates of the 1970s and ’80s, the last stretch of troubling inflation.
“The issue was, the Fed had no credibility and really had to prove it could get inflation under control,” CRFB’s Goldwein said. “Inflation was double-digits, and this isn’t the same situation. Even if they have to create a recession to wrestle inflation under control, there’s no reason to think it has to be as powerful.”
Fed’s communications and balance sheet plans could also zap up extra stimulus
The Fed has more than one stimulus vacuum. In addition to raising interest rates, it’s also readying to reduce the near $9 trillion bond portfolio. Such moves have a more pronounced effect on increasing longer-term borrowing rates, such as mortgages, and the 10-year Treasury.
The Fed is likely to announce how it plans to reduce those holdings at its May gathering, with the process officially starting in June. Yet, even the mere expectation of an impending bond drawdown has managed to push up longer-term borrowing costs.
The average 30-year fixed rate mortgage rose to 5.14% in the week that ended April 12, the highest point in more than 11 years, according to national Bankrate survey data. The 10-year Treasury yield climbed 125 basis points since the Fed’s December meeting, reaching 2.72%, the highest since March 2019.
Most of the time, U.S. consumers’ largest liability is their mortgage loan, and even the slightest movement in mortgage rates can dramatically influence housing demand and home prices. Experts say those increases can cascade throughout the economy in a fashion even more dramatic than hikes to the fed funds rate.
“Their strategy must be to suppress demand in the overall sense of raising interest rates, and they have already done that, even though they already had one hike under their belt,” said Wilmington Trust’s Tilley.
Tighter financial conditions could also play a prominent role in slowing demand because it might shift investors away from riskier assets such as stocks, which boomed during the Fed’s ultra-accommodative policies. Less demand for equities often translates weighs on corporate and household balance sheets.
“If interest rates are doing their jobs, we’re not going to see big increases in home values or stock values,” CRFB’s Goldwein said. “That doesn’t feel good for people who have all this wealth in their stock portfolios or homes, but it’s macroeconomically desirable.”
Fed has less slack in the labor market as it starts this tightening cycle
Powell pointed to three previous instances when the Fed was able to soft land the economy, the most recent 1994. Officials hiked interest rates six times that year, two of those moves in 50-basis-point increments and another by a whopping 75 basis points.
It’s also dramatically different from today. For starters, inflation averaged 2.6% in 1994 and the labor market wasn’t as tight, with unemployment then falling to a low of 5.5%.
“We’ve put our economy on a heat freeze, then defrosted it and then added a war in Europe on top of it,” Harvard’s Greene said. “There are so many uncertainties and idiosyncrasies. It’s hard to know if history can be a guide.”
Though a recession isn’t Greene’s base case, higher joblessness will make it harder to tell the difference. Greene references one of labor economists’ favorite recession indicators: the Sahm rule, which said that a recession has begun if the three-month moving average in the national unemployment rate has risen by 0.5 percentage points from its previous low.
“Given that unemployment is so low, we can expect unemployment to tick up,” she said.
Still, the labor market is tight to an “unhealthy level,” as Powell put it during March testimony with lawmakers. Cooling demand for labor and engineering more slack in the economy at a time when employers have 11.3 million job openings and the prime-age labor force is just 635,000 people shy of pre-pandemic levels might be what the Fed wants, according to an analysis from Stephen Stanley, chief economist at Amherst Pierpont.
Fed’s worst choice: High inflation or recession?
Consumers can infer that Powell’s dove days are over, but he has just one vote. How high the Fed is willing to take rates – and consequently, how much it wants to slow the economy – to avoid a repeat of the ’70s and ’80s depends on the broader views of the Federal Open Market Committee, or FOMC.
Inflation could still slow this year as supply bottlenecks resolve and virus cases abate, but price pressures are still the prominent concern.
“There’s no doubt in my mind that the Fed would choose to cause the recession and stop what happened in the 1970s from happening again,” economist Tilley said. “The Fed does not lose sleep at night thinking about recessions. Recessions are a part of the job, and their job is to mitigate the impact of a recession. They do lose sleep over repeating the mistake of the 1970s.”
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