Aggressive Fed rate hikes increase likelihood of recession | Company
WASHINGTON (AP) — Federal Reserve Chairman Jerome Powell has pledged to do whatever it takes to rein in inflation, which is now raging to its highest level in four decades and defying efforts to the Fed so far to tame it.
Increasingly, it seems, this could necessitate the one painful thing the Fed has sought to avoid: a recession.
A worse-than-expected inflation report for May – consumer prices jumped 8.6% from a year earlier, the biggest jump since 1981 – prompted the Fed to hike its interest rate benchmark by three-quarters of a point on Wednesday.
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Not since 1994 has the central bank raised its key rate so much at once. And until Friday’s poor inflation report, traders and economists were expecting rates to hike just half a percentage point on Wednesday. In addition, several other hikes are to come.
The “soft landing” the Fed had hoped to achieve — slowing inflation to its 2% target without derailing the economy — is becoming both trickier and riskier than what Powell had bargained for. Every rate hike means higher borrowing costs for consumers and businesses. And whenever potential borrowers find lending rates prohibitive, the resulting drop in spending weakens confidence, job growth and overall economic strength.
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“We have a path to get there,” Powell said Wednesday, referring to a soft landing. “It doesn’t get easier. It gets harder”
It has always been difficult: the Fed has failed to stage a soft landing since the mid-1990s. And Powell’s Fed, which was slow to recognize the magnitude of the inflationary threat, must now catch up its delay with an aggressive series of rate hikes.
“They tell you, ‘We’ll do whatever it takes to get inflation down to 2%,'” said Simona Mocuta, chief economist at State Street Global Advisors. “Hopefully the (inflation) data won’t force them to do what they’re ready to do. There will be a cost.”
According to Mocuta, the risk of a recession is now probably 50-50.
“It’s not like you can’t avoid it,” she said. “But it’s going to be hard to avoid it.”
The Fed itself recognizes that higher rates will cause damage, although it does not foresee a recession: On Wednesday, the Fed predicted that the economy will grow by around 1.7% this year, a strong down from the 2.8% growth it had forecast in March. And he expects unemployment to average 3.7% at the end of the year.
But speaking at a press conference on Wednesday, Powell dismissed any notion that the Fed must inevitably cause a recession as the price of controlling inflation.
“We’re not trying to cause a recession,” he said. “Let’s be clear about this.”
Economic history suggests, however, that aggressive, growth-killing rate hikes may be needed to finally get inflation under control. And usually that’s a prescription for a recession.
Indeed, since 1955, each time inflation has exceeded 4% and unemployment has fallen below 5%, the economy has fallen into recession within two years, according to an article published this year by the former secretary Treasury Lawrence Summers and his Harvard University colleague, Alex Domash. The US unemployment rate is now 3.6% and inflation has topped 8% every month since March.
Inflation in the United States, which had been subdued since the early 1980s, resurfaced with vigor just over a year ago, largely due to the economy’s surprisingly strong recovery from the pandemic recession. The rebound took businesses by surprise and led to shortages, delayed deliveries and higher prices.
President Joe Biden’s $1.9 trillion stimulus package added heat in March 2021 to an already warming economy. So does the Fed’s decision to continue the easy money policies — keeping short-term rates at zero and pumping money into the economy by buying bonds — that it enacted there. has two years to guide the economy through the pandemic.
Only three months ago, the Fed started raising rates. In May, Powell promised to keep raising rates until the Fed sees “clear and convincing evidence that inflation is falling.”
Some of the factors behind the economic recovery have since faded away. Federal relief payments are long gone. Americans’ savings, boosted by government stimulus checks, have fallen back below pre-pandemic levels.
And inflation itself has devoured Americans’ purchasing power, leaving them to spend less in stores and online: after adjusting for rising prices, the average hourly wage fell 3% on the month last year over the previous year, the 14th consecutive decline. On Wednesday, the government announced that retail sales fell 0.3% in May, the first drop since December.
Now, rising rates will squeeze the economy even more. Home and auto buyers will absorb higher borrowing costs, and some will delay or scale back their purchases. Businesses will also pay more to borrow.
And there’s another byproduct of the Fed’s rate hikes: The dollar will likely rise as investors buy US Treasuries to capitalize on higher yields. A rising dollar hurts American businesses and the economy by making American products more expensive and harder to sell abroad. On the other hand, it makes imports cheaper in the United States, thus helping to alleviate some inflationary pressures.
The US economy is still strong. The labor market is booming. Employers have added an average of 545,000 jobs per month over the past year. Unemployment is near its lowest level in 50 years. And there are now about two job openings for every unemployed American.
Families are not in debt like they were before the Great Recession of 2007-2009. Nor did banks and other lenders hoard risky loans like they did back then.
Still, Robert Tipp, chief investment strategist at PGIM Fixed Income, said recession risks are rising, and not just because of Fed rate hikes. The growing fear is that inflation is so intractable that it can only be brought under control by aggressive rate hikes that put the economy at risk.
“The risk is up,” Tipp said, “because the inflation numbers have come in so high, so strong.”
All of this makes the Fed’s action to control inflation and avoid recession even more treacherous.
“It’s going to be a tightrope walk,” said Thomas Garretson, senior portfolio strategist at RBC Wealth Management. “It won’t be easy.”