Update 616 — Fueling Uncertainty:
Fed Fights Inflation, Recession Risk
Federal Reserve Chair Jerome Powell took the hot seat this week during the semiannual Humphrey-Hawkins hearings before Congress. Recently re-confirmed as Chair, Powell had to manage his way through cross examination regarding the Fed and inflation, following a hot 8.6 percent May CPI rise in inflation and the Fed’s 75-basis point interest rate hike last week.
Powell seeks to execute a soft landing — a return to targeted, i.e., two percent, inflation without triggering a recession. In the postwar period, a soft landing has only been achieved four times out of the last 12 interest rate cycles. The daunting odds before Powell, his limited tools, and his “unconditional” attack on inflation have raised concerns about a recession, a new uncertainty voiced in the hearings, which we cover below.
Today, we saw one of our fundamental rights denied in the Supreme Court ruling in Dobbs v. Jackson, a ruling which will itself face judgment in the court of public opinion this fall. There is no economic justice without reproductive justice.
For now, good weekends, all…
Inflation — Supplying As to Demanding Qs
The Federal Reserve Chair continued to face questions about inflation during both Humphrey-Hawkins hearings this week. Powell was buffeted with questions regarding elevated prices from both sides of the aisle. Members of Congress sought answers as to what the government can do to alleviate inflation. Some Republicans voiced support for the Fed’s recent decision to pursue more aggressive interest rate hikes, but other Republicans and most Democrats voiced concerns about the Fed overshooting and inducing a recession. When members attempted to get Powell to comment on the inflationary impacts of fiscal policy, Powell refused to answer and instead cited the Fed’s outlined jurisdiction of monetary policy.
Powell had to walk these concerns on a tightrope. Powell referenced the Fed’s desire to achieve a soft landing by cooling inflation without significantly harming the economic recovery and expansion, saying, “What we’re trying to achieve is to have a moderation in demand so that supply can catch up, and so that that will take pressure off of resource utilization, and inflation can come down.” The quantitative goal is to bring inflation down to its 2 percent average targeted rate while maintaining a strong labor market. However, Powell made clear the risks on either side of missing the soft landing: overshoot and we face a recession, undershoot and inflation persists for a longer stretch.
Powell did highlight some underlying strength in the American economy. Households have amassed significant excess savings during the pandemic that could keep consumer spending resilient to currently high inflation and rising borrowing costs. This is particularly true for the bottom half in wealth distribution, which has seen a 97 percent increase in its wealth since the pandemic started. These gains are one of the reasons why many members are concerned about the Fed unnecessarily inducing a recession. Senator Menendez connected those concerns to the populations that would be disproportionately impacted by a recession: Black and Brown workers who have been historically marginalized. The current recovery has helped these workers with pay increases and employment gains, but a recession threatens these benefits.
Supply-Driven and Demand-Driven Contributions to Year-Over-Year PCE Inflation
Source: FRBSF Economic Letter
Fed’s Policy (sans Leak) Set on Repeat
Several published forecasts over the past month showed they had raised the likelihood of a recession as market observers began to propose the Federal Reserve take a more aggressive approach to taming inflation. Invoking themes from the Volcker Shock from 1979 to 1982, more hawkish policymakers have called on the Fed to hike interest rates at a quicker pace. Senator Tillis referenced the Taylor Rule, a somewhat niche mathematical rule to tie interest rates and inflation into a relationship, to argue that the Federal Funds Rate should be higher than 6 percent.
Already, it seems the Fed is keen on moving more aggressively than had been thought. The central bank leaked a last-minute policy change alerting markets that last week’s rate hike would be 75 basis points, not the previously stated 50 basis points. The Federal Open Market Committee revised higher its expected path for the fed funds rate over the next three years.
The leak allowed markets to price in the change ahead of time and gave the Fed some credibility in fighting inflation. The move came at the expense of some market trust in the Fed’s ability to communicate policy ahead of time. That erosion of trust could haunt the Fed if it struggles to bring policy expectations in line. But it could pay off if inflation expectations remain anchored.
There are multiple signs financial tightening is already putting downward pressure on the economy. Mortgage rates have been increasing following the series of rate hikes over the past few months. The upward trajectory of mortgage rates has already slowed housing starts and sales. Cooling down the housing market is a critical step in fighting inflation, but there is a long-term downside to cooling down the housing market as constricted supply will push housing prices up in the long-run.
Energy and food prices continue to remain elevated and are the most visible prices consumers see on a daily basis. Raising interest rates doesn’t have much influence, if any at all, on these prices, as Powell admitted to Senator Warren. Rising rates could curtail investments in expanding production which will only prolong supply constraints. Powell’s admission and the potentially counterproductive effects of tighter monetary policy today on long-run inflation make the 75 basis point hike even more puzzling. If the Fed can’t bring down energy and food prices but ends up jamming up capital investments, the Fed may be unnecessarily digging a deep hole for the economy.
The Rest of the Year
When Powell comes back before Congress this winter, the next hearings will focus on the way the Fed handled inflation. Powell signaled the Fed will be raising rates to between 3 and 3.5 percent by the end of the year. Senator Rounds predicted that if Powell and the Fed get this wrong, Powell will be the one to take the fall. And Senator Rounds is likely correct. If the Fed succeeds, the White House will hoist Powell up as a hero and pat themselves on the back for trusting the Fed. But if we continue to see high inflation or enter a recession, there will be tangible frustration with Powell and his leadership.
There are multiple personnel matters policy debates outside inflation and systemic risk that the Fed will need to address:
- Vice Chair for Supervision: The Fed is awaiting a final vote on Michael Barr to serve as the Vice Chair of Supervision. That role will be even more important given the financial tightening across the economy that could open up the financial sector to serious risks, despite the sector largely standing on solid ground at the moment.
- Regulatory Agenda: There will need to be revisions of the Trump-era rollbacks of regulatory policy, covering liquidity requirements and stress tests, orchestrated by the previous Vice Chair of Supervision, Randal Quarles.
- Updated Community Reinvestment Act: The proposal for updates to the Community Reinvestment Act is still going through the public comment period. While the updated CRA should not be a contentious fight, it is still incredibly important given the outdated language of the rules.
- Cryptocurrency: The Fed will need to tackle cryptocurrency as well, both from the view of developing and enacting regulation on private cryptos and stablecoins and continuing research on the development of a central bank digital currency.
The next half a year may be one of the most important periods of time for the Fed since the rapid inflation of the 70s and 80s. Warranted or not, much of the political system — and especially the Biden administration— have put faith in the Fed to handle inflation. The Fed now fixes to thread the needle and navigate a soft landing.The Fed is clear-eyes about the job and concedes its tools are limited and blunt, a fact Powell referred to multiple times during the hearings.
The administration, the markets, and the rest of the country now repose such hope as they can muster and look toward the often-shrouded institution of the Federal Reserve to guide us through the tumultuous seas of the post-pandemic economy.