What if the Fed’s own forecasts were wrong?

Projections from Fed governors will always paint a rosy picture. They are in charge of conditioning their point of view on an optimal monetary policy, which obviously allows to obtain better results. In the real world, as has been demonstrated over the past year, politics often fall far short of this ideal, so actual results will generally be worse than the projections imply.

Along the same lines, the Fed’s model that underlies its staff forecast contains assumptions that contribute to more pleasing forecasts. They include that the Fed will continue on the optimal monetary policy path in the future (regardless of past mistakes) and that households and businesses know this.

These assumptions rule out persistent monetary policy errors or loss of household and business confidence in the Fed’s commitment and ability to meet its employment and inflation targets.

The Fed also operates in a world where there is a significant political economy constraint. Admitting that a recession would be necessary to control inflation could undermine public support for tighter monetary policy. It could also subject the Fed to criticism that could ultimately undermine its independence or cause Congress to limit its authority in the future. Covering the cost of what the Fed has to do can be seen as a necessary evil for it to be able to carry out its mission. But it also risks undermining the Fed’s credibility.

Why do I believe a recession is inevitable? For starters, the Fed has pledged to bring inflation back to its 2% annual rate target. Powell made it clear in his remarks at the Jackson Hole conference in August that that goal was “unconditional” and reiterated his commitment at his September press conference. later.

To bring inflation down to 2%, the Federal Open Market Committee will have to raise the unemployment rate substantially. The labor market is much too tight to be compatible with a stable or falling underlying inflation rate.

Judging by the relationship between unfilled job vacancies and the number of unemployed people, known as the Beveridge curve, the unemployment rate consistent with stable inflation has increased significantly and could reach 5%, although above the current rate of 3.7%. . Even if the Beveridge curve were to come back down as frictions in the labor market eased, the unemployment rate should still climb back up to at least 4.5%.

During the post-war period, each time the unemployment rate increased by 0.5 percentage points or more, the US economy entered a recession. This empirical regularity is commemorated as Sahm’s rule. The difficulty of staging a soft landing is underscored by the fact that there are no examples of the unemployment rate rising between 0.5 and 2 percentage points from trough to peak. Once the unemployment rate has increased slightly, it is difficult to stop. Thus, the Fed’s September summary of economic projections in which unemployment climbs to 4.4% from its recent low of 3.5% would be unprecedented.

The episodes cited by Powell of successful soft landings – in 1965-66, 1984-85 and 1993-95 – do not apply to current circumstances. In these cases the Fed tightened and this slowed the pace of economic growth and the decline in the unemployment rate, but in none of these episodes did the Fed tighten enough to push the unemployment rate up. In Fed parlance, these soft landings were achieved from the top, slowing the economy to a sustainable rate of growth, rather than from the bottom, slowing the economy enough to drive up the unemployment rate.

The Fed’s risk management will also increase the likelihood of a recession. Powell made it clear that the consequences of failing to bring inflation down to 2% sustainably are unacceptable. The lesson of the 1970s is that failure would lead to unanchored inflation expectations, making it all the more difficult to restore price stability.

Additionally, the Fed’s task will be made difficult by uncertainty about whether it has done enough. How high should short-term interest rates rise to push the unemployment rate above the rate consistent with stable inflation? How long does it take to increase such an unemployment rate to bring inflation down to 2%? Since at the margin the negative consequences of doing too little outweigh the negative consequences of doing too much, this means that monetary policy will likely end up remaining too tight for too long. The long and variable lags between changes in monetary policy stance and their effects on economic activity reinforce this situation.

Some argue, including Fed officials, that a soft landing is still possible:• As supply chain disruptions dissipate and the distribution of demand between goods and services normalizes , headline inflation will fall sharply. • Labor supply will increase as labor force participation rises. • Fed tightening may reduce excess demand for labor without generating strong unemployment increase.

While these points cannot be dismissed out of hand, I fear they will prove insufficient to avoid a hard landing.

First, even if lower goods prices lead to a sharp drop in headline inflation over the coming year, this does not solve the fact that the inflation problem has spread to the prices of services and to wages.

The extent of inflationary pressures can be seen in the median consumer price index calculated by the Federal Reserve Bank of Cleveland and the reduced average personal consumption expenditure deflator – an alternative measure of inflation calculated by the Federal Reserve Bank of Dallas – with increases of 7% and 4.7%, respectively, over the past year. These numbers capture what happens to these goods and services in the middle of the inflation distribution.

Similarly, the trend in wage inflation is well above a rate compatible with 2% inflation. For example, the employment cost index for wages and salaries of private sector workers has risen 5.2% over the past year, and the Federal Reserve Bank’s wage tracking index of Atlanta is growing at an annual rate of 6.4%. Given the labor productivity trend, wage inflation needs to be in the 3% to 4% range to be in line with the Fed’s 2% inflation target.

Second, on the labor supply front, the Fed is unlikely to be bailed out by a sharp increase in labor force participation. As labor economist Stephanie Aaronson noted in her remarks at this year’s Jackson Hole Fed conference: “The unemployment rate is the best indicator of the state of the business cycle. While a tight labor market might be expected to cause an increase in participation, she said, the process is slow, taking place over several years, a process too slow to save the economy. fed.

Third, the idea that tight monetary policy from the Fed can be directed towards reducing excess demand for labor without significantly increasing unemployment is wishful thinking. Monetary policy cannot be targeted to reduce the demand for labor in industries where demand is excessive relative to industries where supply and demand for labor are better balanced. It is a blunt tool that affects the wider economy through its impact on financial conditions.

Although a soft landing is obviously preferable, this ship sailed. Today, a recession is virtually inevitable.

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