What if the Fed’s own forecasts are wrong?

Fed governors’ projections will always paint a rosy picture. They are in charge of conditioning their opinion on an optimal monetary policy, which of course makes better outcomes possible. In the real world, as has been shown over the last year, politics are often far from that ideal, so actual outcomes will generally be worse than those implied by projections.

Similarly, the Fed’s model that underpins its staffing forecasts contains assumptions that contribute to more pleasing forecasts. They include that the Fed will pursue the optimal monetary policy path going forward (regardless of past mistakes) and that households and businesses know it.

These assumptions rule out persistent monetary policy errors or loss of confidence by households and businesses in the Fed’s commitment and ability to meet its jobs and inflation targets.

The Fed also operates in a world where there is an important constraint of political economy. Admitting that a recession would be needed to keep inflation in check could weaken 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. Softening the cost of what the Fed needs to do can be seen as a necessary evil so that it can successfully accomplish its mission. But it also runs the risk of undermining the Fed’s credibility.

Why do I believe a recession is inevitable? To start, the Fed pledged to cut inflation to its 2% annual rate target. Powell made it clear in his remarks at the Jackson Hole conference in August that this goal was “unconditional” and reaffirmed his commitment at his September press conference. Bankruptcy is an unattractive option because inflation expectations would rise, requiring tougher monetary policy and worse outcomes afterward.

To bring inflation to 2%, the Federal Open Market Committee will have to significantly increase the unemployment rate. The labor market is too tight to be consistent with a stable or declining underlying inflation rate.

Judging by the relationship between job vacancies and the number of unemployed, known as the Beveridge curve, the unemployment rate consistent with stable inflation has risen considerably and could reach 5%, well above the current rate of 3 .7%. . Even if the Beveridge curve were to retract as labor market frictions eased, the unemployment rate would still need to rise to at least 4.5%.

In the postwar period, every time the unemployment rate rose by 0.5 percentage point or more, the US economy fell into a recession. This empirical regularity is commemorated as Sahm’s rule. The difficulty of engineering a soft landing is underlined by the fact that there are no examples of an unemployment rate rising between 0.5 and 2 percentage points from trough to peak. Once the unemployment rate has risen slightly, it’s hard to stop. Thus, the Fed’s recap of economic projections in September, in which unemployment rises to 4.4% from its recent low of 3.5%, would be unprecedented.

The incidents Powell cited of successful soft landings – in 1965-66, 1984-85 and 1993-95 – do not apply to the current set of circumstances. In those cases, the Fed tightened and that 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 drive up the unemployment rate. In the Fed’s parlance, these soft landings were achieved from above, slowing the economy to a sustainable rate of growth, rather than from below, slowing the economy just 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 back to 2% on a sustainable basis are unacceptable. The lesson of the 1970s is that bankruptcy would lead to unanchored inflation expectations, making the task of restoring price stability much more difficult.

Furthermore, the Fed’s job will be made difficult by uncertainty about whether it has done enough. How far do short-term interest rates have to go to push the unemployment rate above the rate consistent with stable inflation? How long does such an unemployment rate need to be high to bring inflation back 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 eventually be kept too tight for too long. The long and variable intervals between changes in the stance of monetary policy and its effects on economic activity reinforce it.

Some argue, including Fed officials, that a soft landing is still possible: • As supply chain disruptions dissipate and the allocation of demand between goods and services normalizes, overall inflation will decline sharply. • Labor supply will increase as labor force participation increases. • Fed tightening can reduce excess demand for labor without generating a large rise in unemployment.

While these points cannot be ruled out a priori, I fear they will probably prove insufficient to avoid a hard landing.

First, even if falling goods prices cause a sharp drop in headline inflation in the year ahead, this does not solve the fact that the inflation problem has spread to services prices and wages.

The magnitude 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 by 7% and 4.7%, respectively, in the last year. Those numbers capture what’s happening for those goods and services in the midst of the inflation distribution.

Similarly, the trend in wage inflation is well above a rate consistent with 2% inflation. For example, the Labor Cost Index for wages and salaries for private industry workers increased 5.2% over the past year, and the Federal Reserve Bank of Atlanta’s wage index is increasing at a rate 6.4% annually. Given labor productivity trends, wage inflation needs to be between 3% and 4% to be consistent 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.” she, she said, the process is slow, it takes place over several years, too slow a process to save the Fed.

Third, the idea that the Fed’s monetary policy rigor can be geared toward reducing excess labor demand without materially increasing unemployment is wishful thinking. Monetary policy cannot be targeted in such a way as to reduce the demand for labor in sectors where demand is excessive as opposed to sectors where labor supply and demand are in better balance. It is a blunt instrument that affects the broader economy through its impact on financial condition.

While a soft landing would obviously be preferable, that ship has sailed. Today, a recession is virtually inevitable.

This story was published from a news agency feed with no text edits.

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