There Will Be Pain

Now we know where the American economy is headed. More precisely, we now know where the Federal Reserve Board’s monetary policymakers believe they are taking us.

Chairman Powell has warned there will be pain to drive inflation out of the system, and he now offers the Fed’s view of just how much. Last week he raised the Fed’s benchmark interest rate by 0.75 per cent, and in effect announced 1.25 per cent in additional increases this year, in two tranches. That would bring the key interest rate to 4.4 per cent at year end, about where it was at the end of 2007, and within the 4.0 and 4.5 per cent range to which most of the members of the 12-person policy committee expect to raise rates by year-end, before moving to 4.6 per cent at the end of 2023.

There’s more. The current medicine plus renewals of the prescription will not reduce the inflation rate to the Fed’s 2 per cent target until 2025. Meanwhile the unemployment rate will rise this year alone from 3.7 per cent to somewhere between 4.4 and 4.5 percent next year.

That means higher mortgage rates, increased charges on credit card balances, higher interest rates on car purchases. Those will hurt. But not quite as much as the increase in the unemployment rate from 3.7 per cent to 4.4 per cent by the end of 2023. That comes to about 1.5 million workers moving from offices and factories to the unemployment queue, assuming that the 11 million job openings now available will have faded into the history books.

And It Will Be Worth It Says Powell And His Team Of 400 Seers

Still, if we end up with a low-inflation economy and an unemployment rate in the mid-four per cent range, Powell will feel he has won and most experts will agree with him. One problem is that the Fed’s forecasting record is far from impeccable. Advised by its 400 Ph.D. economists, the policy committee was still calling inflation “”transitory” only nine months ago – “it won’t leave a permanent mark in the form of higher inflation” said Powell.

In December, the committee declared that the target interest rate needed to fight inflation would be 0.9 per cent at the end of this year. In March it raised that year-end forecast to 1.9 per cent, then to 3.4 per cent in June and now to 4.4 per cent.

The policy committee has two more meetings this year, and it is not unreasonable to suspect it will again increase its opinion of the interest rate needed to crush inflation. That would cause the economy to shrink rather than grow at the 0.2 per cent rate the Fed is forecasting, and unemployment to increase even further. That’s called Stagflation, not a soft landing.

Another possible problem is that the Fed is laying out its proposal using the wrong metric. In economists’ jargon, it is positing the effects of nominal rather than real interest rates when it is the latter that really matter. Andrew Levin and Mickey Levy, visiting scholars at the Hoover Institution and members of the highly respected independent committee that “shadows” the Fed, point out that a fed-funds rate of 4.25 per cent will prove severely inadequate if core inflation keeps running above 4 per cent. In that case, the nominal 4 per cent rate would in real terms be negative, and generate upward pressure on spending. They write, “Elevated inflation would persist and become more deeply entrenched or even spiral further upward.”

Brake But Do Not Break

Then there is a problem not of the Fed’s making, but one that worries those who fear that braking the economy will morph into breaking the economy. The Fed has no way of knowing when to stop raising rates, since the effect of any increase, perhaps with a few exceptions (housing, cars), is only felt after a lag variously estimated at between six and twelve months. The Powell team must decide on its next move with no more than a guess as to whether they are at the end of the beginning of their inflation fight, or the beginning of the end, or the end.

The fear among many investors and analysts was best summarized by J.P. Morgan Asset Management’s David Kelly. He worries that the Fed tends to start too late, go too high and stay there too long. Others fear the opposite: that the Fed is being excessively optimistic in assuming that the medicine it is prescribing can produce the result it is predicting, reasonably close to the much-  desired but rarely obtained “soft landing”.

The Political Climate Heats Up

They expect that it will take a stronger potion with more powerful negative effects on growth and employment than Powell is anticipating to bring inflation down to 2 per cent by 2025. Powell is already under pressure from the left wing of the Democratic Party to stay his hand, lest millions of workers, most likely black and Hispanic, are laid off.

Further tightening would turn up the political heat. Powell promises to take that heat to cool the economy, which is why central bank independence is so important. Some presidents – Lyndon Johnson, Richard Nixon, Donald Trump – have challenged that independence, but Biden has not. Yet.