https://www.wsj.com/articles/inflation-jobs-fed-recession-economy-11650294297?mod=hp_lead_pos9
The Federal Reserve is setting out to do something it has never accomplished before: reduce inflation a lot without significantly raising unemployment.
Central bank officials think it is possible with calibrated interest rate increases that slow booming demand just enough to take steam out of an overheated economy. But even one of the Fed’s closest allies, U.S. Treasury Secretary Janet Yellen, sees the risk of failure. “It will require skill and also good luck,” the former Fed chair said in public comments in Washington last week.
During the past 80 years, the Fed has never lowered inflation as much as it is setting out to do now—by four percentage points—without causing recession. In this case, the central bank will need a number of factors out of its control to break its way.
Still, Fed officials can find reason for both optimism and caution from history. In seven different episodes during the past 80 years, inflation has fallen as much as the Fed bank wants it to drop now, with varying outcomes. The episodes suggest that the desired scenario is theoretically possible though the risk of failure is high, especially because the bank is chasing inflation that already exists, rather than addressing the problem before it arises as it did in some earlier episodes.
“No one expects that bringing about a soft landing will be straightforward in the current context—very little is straightforward in the current context,” Fed Chairman Jerome Powell said last month. The central bank, he added, faces a “challenging task.”
During the early 1980s, the U.S. experienced a classic hard-landing as economists dub it—falling into a deep recession with double-digit unemployment after the Fed pushed its benchmark interest rate to nearly 20% to tame stubbornly high inflation that had been rising for more than a decade.
The U.S. had less severe, but bumpy landings during the 1950s, characterized by short-lived inflation spikes and recessions. During that period, the unemployment rate rarely got very high even when economic output contracted.
The 1970s delivered aborted landings, when inflation fell and then lurched higher, beset by outside shocks such as OPEC oil embargoes and policy missteps including a central bank that hesitated to raise interest rates aggressively.
The U.S. has had soft landings, too, most recently in 1994. Fed Chairman Alan Greenspan sharply raised rates to 6% in February 1995 from 3% one year earlier, and the unemployment rate kept going down. Unlike 1994, however, the Fed today is trying to reduce inflation that is already too high rather than prevent it from rising, as Mr. Greenspan did back then.
In the scenario Fed officials mapped out, their benchmark interest rate will rise to around 2.75% by the end of next year, just above estimates of a rate that neither spurs nor slows growth.
They project inflation will drop to slightly above 2% by 2024, a rare four-percentage-point decline in less than three years. They see economic output growing at a rate between 2% and 3% while unemployment holds below 4%.
John Taylor, an economist at Stanford University who is the author of an influential policy-setting rule of thumb called the “Taylor rule,” says his formula calls for the Fed to set interest rates at 5% right now. Because the Fed is unlikely to lift rates so dramatically in one year, he said officials instead ought to raise rates to 3% by December and signal more increases after that unless inflation comes down.
“This is not the only time in history that they’ve been behind, but they are strikingly behind,” said Mr. Taylor. “They need to catch up and do it in a systematic and understandable way.”
The Fed’s success will depend on several factors outside its control. Those include whether global energy supplies recover from the shock of Russia’s invasion of Ukraine, reducing energy prices; whether sidelined U.S. workers rejoin the labor force, easing the labor shortage and wage pressures; whether Chinese plants reopen in the face of more Covid-19 lockdowns, clearing supply bottlenecks; and whether Covid itself recedes for good in the U.S., ending related pandemic-related economic disruptions.
The Fed’s job will be easier if these supply constraints ease. If they don’t, the central bank will need to push rates higher to squeeze demand, with a risk of more damage to the economy.
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