“A hellishly difficult task.” Can the Federal Reserve lower inflation without causing a recession?

Now with inflation recently Reaching its highest level since 1982, the Fed is preparing to return to its conventional inflation-fighting playbook – but this time there’s hope it can skip the recession part.

The unique effects of COVID-19 have created the possibility that history will not repeat itself and that inflation may be brought under control without shrinking the economy, economists have said. But that’s only possible if Fed Chairman Jerome Powell and other central bank policymakers act cautiously and quickly amid unprecedented supply chain and labor issues. of the evolving pandemic.

“The virus is unpredictable. People’s reactions to the virus are unpredictable. This is by no means a garden variety business cycle,” said Donald Kohn, senior fellow at the Brookings Institution think tank who served as Fed vice chairman from 2006 to 2010. “It is much more difficult to look to the future and know how to calibrate monetary policy.”

Bernard Baumohl, chief global economist at the Economic Outlook Group, a forecasting firm, was more blunt.

“The Fed has a hell of a tough job right now,” he said. “There is absolutely no history that the Fed can rely on to deal with this type of inflation.”

Much depends – economically and politically – on the ability of the Fed to achieve this.

The arrival of COVID-19 in early 2020 and subsequent shutdowns immediately plunged the United States into a severe recession. More than 22 million people have lost their jobs, pushing the unemployment rate to 14.7%, the worst since the Great Depression. But the economy quickly rebounded as businesses reopened.

The recession technically only lasted two months – the shortest in US history – but the nation is still recovering from its damage. Even after strong economic growth and record job creation last year, the United States had 3.6 million fewer jobs in December than its pre-pandemic level.

Despite the improving economy, consumer confidence began to tumble last spring as prices began to rise sharply. A highly monitored measure The University of Michigan’s consumer sentiment index this month hit its second-lowest level in a decade, largely on inflation concerns after the consumer price index fell. jumped 7% last year. With Americans paying more for gas, food and other essentials than a year ago, a third of Michigan survey respondents said they were worse off financially than a year ago early, just a tick above the April 2020 level amid the COVID shutdowns.

The White House and the Fed, along with most economists, predicted last spring that high inflation would be temporary, pointing to supply chain problems caused by the restarting of the US and global economies. But former Treasury Secretary Lawrence H. Summers and some other economists have warned that the $1.9 trillion COVID relief bill passed last March risks fueling longer-lasting inflation by injecting too much money. money in the already recovering US economy.

As inflation grew more persistent, Republicans turned the issue into a partisan hammer, hammering President Biden and the Democrats for driving up the cost of living for the average American. The president’s approval rating has fallen in part because of deteriorating Americans’ views of his economic handling, and inflation is expected to be a major issue in the midterm congressional elections this fall. Nearly two-thirds of respondents in a CBS News/YouGov Poll released this month said Biden was not paying enough attention to inflation.

“One thing has become very clear over the past six months is that people hate inflation much more than economists hate inflation,” Kohn said. “Economists see it going up and down…but people see inflation and they don’t like it.”

In recent months, Biden has acknowledged inflation as a problem and said he is trying to solve it by working to reduce supply chain bottlenecks, increase oil supplies and to promote competition in highly concentrated markets such as meat processing. He also argued that parts of his rogue social spending and climate change legislation would mitigate the impact of inflation by reducing other household costs, such as prescription drugs, childcare and energy.

“It won’t be easy, but I think we can get there,” Biden said at his Wednesday press conference when asked about reducing inflation. “But it’s going to be painful for a lot of people in the meantime.”

Still, he noted that the Fed, which is independent of the White House, plays a critical role in fighting inflation.

Maintaining price stability is half of the central bank’s dual mandate; the other is the promotion of as many jobs as possible. But with the jobless rate falling to 3.9% in December, the Fed is shifting into inflation-fighting mode — the so-called “Powell Pivot” — after boosting the labor market since early 2020 by maintaining its benchmark short-term interest rate close to zero and buy hundreds of billions of dollars worth of bonds.

“We need to achieve price stability, and I believe we will, and I’m confident we will,” Powell told the Senate Banking Committee Jan. 11 during a hearing on his renomination by Biden for four more years as Fed Chairman.

The Fed has the most powerful direct tool to reduce inflation: the ability to manipulate interest rates. It now expects it to raise its benchmark rate to almost 1% this year while ending its bond-buying program, which allowed money to circulate in financial markets and stabilized long-term interest rates. Fed officials believe the combination will slow the economy just enough to reduce inflation without causing a recession.

Economists aren’t as confident, but said it’s possible depending on how the pandemic evolves.

“I think the Fed can calibrate things carefully and gradually so that we don’t plunge into a recession,” said Kathy Bostjancic, chief U.S. financial economist at Oxford Economics, a global forecasting and forecasting firm. ‘to analyse. “But it’s a challenge because historically we all know that the Federal Reserve and other central banks have failed to navigate a soft landing in the economy.”

The most recent example dates back to the early 1980s, when the Fed’s aggressive actions to fight inflation caused a short recession in 1980 and a longer and more severe one in 1981-82. But inflation had been building up for years at the time, requiring a much more forceful response that eventually pushed interest rates close to 20%. Circumstances today are very different, with inflation surging after decades of low inflation.

“The only reason we have this spike in inflation now is that we’ve been hit by a shock, an unprecedented type of shock,” Baumohl said. “In some ways you can think of it as an earthquake that happened in 2020 and we had these aftershocks following the additional variants.”

He expects inflation to peak in the first three months of this year as economic growth slows – but does not stagnate – with less federal stimulus spending and supply chain constraints s attenuate. This would allow the Fed to slightly slow interest rate hikes and keep the economy out of recession. Powell and Fed officials will need to tread carefully and not overreact to inflation, Baumohl said.

The Fed is also acting at a time when its influence on the economy may be weaker than in the past. The pandemic has distorted the economy to the point that conventional Fed tools, like interest rate hikes, are limited in their effectiveness, said Stephanie Kelton, professor of economics and public policy at the University of Stony Brook. This forces the Fed to lower inflation, but also makes it harder for the Fed to intervene to cause a recession, she said.

Kelton highlighted used cars and trucks. Their prices jumped 37.3% in 2021, a major factor in the overall rise in inflation. But people aren’t buying used vehicles because they think it’s a good time to do so, she said. They’re buying them because there aren’t as many new vehicles left after production was limited by a shortage of computer chips from pandemic-hit Asian factories.

Since dynamic and increased interest rates for auto loans are unlikely to significantly reduce demand for used cars, Kelton said.

“If you can raise rates but not deter or curb a lot of other activity, you’re not going to cause a recession,” she said.

Other economists, however, see this as a particularly vulnerable time for the economy, with any decision by the Fed to raise rates hampering business owners who need low interest rates to weather pandemic-related disruptions.

“If you raise interest rates, you’re affecting Main Street lending and we don’t want that right now,” said William Spriggs, an economics professor at Howard University and the union federation’s chief economist. AFL-CIO. “Companies need space to ramp up production. Rising interest rates remove this margin.

Spriggs said Powell was responding to political pressure from Republicans to fight inflation despite the difficulty in determining the real reasons for the high prices during an unprecedented pandemic.

“It’s not really inflation. … What we are suffering from is price instability, which is something different,” he said. “That is going to take time [to stabilize] because it’s global and supply disruptions are a global phenomenon.

Kohn acknowledged the difficulty of economic forecasting during the pandemic, but said the Fed’s inability to see that this surge in inflation would be more persistent has hurt its credibility. He credits Powell for quickly changing course, but sees a risk of recession if the Fed has to act more aggressively than it announced this year.

“It’s all built on this very difficult to predict virus,” he said. “For once the word ‘unique’ is justified.”

Jim Puzzanghera can be contacted at [email protected] Follow him on Twitter: @JimPuzzanghera.

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