(Bloomberg Opinion) — Rising hopes for a soft landing for the US economy likely hinge on the Federal Reserve’s willingness to tolerate markedly higher inflation than it would prefer.
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After taking a break from credit tightening last month, Fed Chairman Jerome Powell and his colleagues appear determined to raise interest rates by a quarter of a percentage point this week. The goal: slow the economy enough to bring inflation down to its 2% target over time, without sending the US into a recession, a proverbial soft landing.
The big question facing politicians and financial markets is what comes next. Former Fed Chairman Ben Bernanke said this week’s rate hike may be the central bank’s last in a credit-tightening campaign that has already seen rates rise by five percentage points.
But a lot will depend on how much inflation the Fed is willing to accept and for how long.
In the absence of a recession, it appears that the labor market will remain tight, with the demand for workers continuing to outstrip the supply. That will keep wages high, putting pressure on companies to raise prices to cover their additional labor costs.
“It’s going to be hard to get enough demand compression without a recession to take that price pressure out of the system,” said JPMorgan Chase & Co. chief economist Bruce Kasman. “I don’t think inflation is going to drop below 3% on a sustained basis” otherwise.
As a result, the risk is that the Fed will eventually have to raise rates further after this week’s hike, especially if the US does not fall into recession later this year, Kasman said, although JPMorgan’s official call is that the July push will be the central bank’s last.
“There’s really no evidence that the Fed has done enough to stay out,” said Stifel Financial Corp. chief economist Lindsey Piegza, who sees the central bank eventually raising rates to 6%, from a range of 5% to 5.25% now.
Leading economists who warned the Fed about inflation now differ on how it should proceed.
Allianz SE economic adviser Mohamed El-Erian argues that the US central bank should live with inflation around 3% and not put the economy through a wringer to drive prices down to its 2% target.
Former Treasury Secretary Lawrence Summers says settling for a target of more than 3% now is a bad idea and risks setting the stage for even stronger price growth in the next business cycle.
What Bloomberg Economics Says…
“There are several potential adverse supply shocks on the horizon that could reverse inflation progress, ultimately prompting the Fed to resume raising towards the end of 2024. … For now, we are characterizing the rate path as an ‘extended pause’ after July, with a non-trivial possibility that the Fed could resume raising later.”
— Anna Wong and Stuart Paul, American economists
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The inflation rate has come down significantly from its highs last year. To a large extent, that reflects an easing of price pressures stemming from the Covid-19 pandemic and Russia’s invasion of Ukraine, perhaps most prominently in the oil market.
Reducing inflation in the so-called last mile to an annual rate of 2% is likely to be more difficult because it resides in the service sector, where prices tend to be more sticky and where wages account for a larger share of the costs of running a business.
The personal consumption expenditures price index, the Fed’s favorite inflation gauge, rose 3.8% in May from a year earlier. The core PCE price index, which excludes food and energy costs and which Fed officials say is more representative of underlying trends, rose 4.6%.
“Going the last mile is hard,” said former Fed official Vincent Reinhart, now chief economist at Dreyfus and Mellon. “As a recession becomes more likely, the Fed will abandon its pursuit of price stability.”
Powell insists that the Fed is committed to its 2% inflation target, though he admits it could take some time to reach it, perhaps not until 2025. He also acknowledges that a softer labor market will likely be needed to achieve that target. But he’s betting that that can be done without a significant rise in unemployment and a recession.
Kasman said the monthly inflation figures could remain weak for months to come due to cheaper imports from China, the decongestion of global supply chains and a reduction in rent increases. But he argued that any relief is likely to be short-lived given a continued tight labor market and increased willingness of companies to raise prices.
El-Erian, who is a columnist for Bloomberg Opinion, said the Fed is likely to face a choice in the fourth quarter: press ahead with efforts to bring inflation down to target and risk breaking something in financial markets or the economy, or acknowledge that getting to 2% won’t be easy and be prepared to hit that target again in the future.
He argues that a confluence of factors, including a shakeup of global supply chains and the costs of transitioning to net zero greenhouse gas emissions, suggests the Fed should target inflation at 3%, not 2%.
“If you’re cutting inflation from nine to three, you probably won’t lose credibility by saying we’ll stop at three instead of two,” said Peterson Institute for International Economics president Adam Posen, who also called for a higher target.
Summers, a paid Bloomberg Television contributor, warned that settling for a higher inflation rate now could lead to problems down the road, as underlying forces in the economy push prices higher.
“Whatever target they set, it’s likely to be the low point of the cycle, not the average of the cycle,” he said. “Most likely, during a recovery, inflation will rise.”
“The chances of a soft landing with inflation below 3% are higher than they were, but they are still well below 50%,” he added.
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