The Federal Reserve (Fed) has raised the target for its main policy rate by 50 basis points (bps) to a range of 0.75% to 1%. With the annual rate of consumer inflation at a four-decade high there are fears that recession may be the trade-off for price stability.

Markets are keenly focussed on the statements accompanying these decisions and in particular comments on the economy.

In this regard, markets will be looking for any sign that the bank’s Federal Open Market Committee (FOMC) rate setting committee will not follow through on a series of expected rate hikes at future meetings.

Recession – a necessary trade-off?

Our expectation is that the FOMC will remain committed to further tightening. Indeed, our analysis suggests that a recession may actually be a necessary trade-off for lower inflation, despite hopes of a “soft landing”.

Essentially the central bank has now to restore the balance between supply and demand such that there is sufficient slack in the economy to ease wage and price pressures. To achieve a soft landing, this has to be done gradually with the growth rate slowing below trend rather than crashing into recession with output falling and unemployment rising rapidly.

However, this is easier said than done.

A 50 bps increase in the main policy rate is the largest move at an FOMC meeting since 2000. The federal funds rate, however, remains below the “equilibrium” level most committee members view as consistent with a neutral central bank policy.

Past experience shows the recessions of the 1980s and 1990s followed a similar pick up in inflation to that being experienced today. While there was much talk of achieving a soft landing during these periods, this was not to be.

There are three reasons why the odds on a recession are high at present.

First, inflation is becoming entrenched. Inflation is high and broad based while the labour market is tight. The rise in “sticky” prices is a particular concern as by their nature they move more slowly and take longer to come down. This would allow more time for second round effects to develop where wages follow prices higher leading to a further round of price hikes.

As a result the task for central banks of bringing price rises back to target is made harder: monetary policy needs to tighten by more to bring demand into line with supply, at the cost of a recession.

Second, monetary policy is a blunt tool. Milton Friedman, whose theories underpinned the monetarist policies credited with taming inflation for most of the past four decades, said monetary policy acts with long and variable lags. Confidence effects also play a role. Fears of recession can become self fulfilling for example, resulting in cutbacks in spending.

Central bank models give policymakers an indication of how long those lags are, but they are not precise. Judging how tight policy needs to be is difficult and the temptation is to keep raising rates until something breaks. This was very much the pattern in the 1980s and 1990s.

Third, that policy judgement is made more complex today by what is happening elsewhere.

Monetary policy is tightening or set to tighten around the world in response to inflation, not just in the US. Global trade and external demand will be weaker as a result.
Activity in Europe is significantly affected by the war in Ukraine and ongoing efforts to embargo Russian energy. The rise in commodity prices acts as a tax on consumption, reducing real incomes and spending around the world.
China is not tightening monetary policy, but the zero Covid policy is hammering the economy.
Finally, fiscal policy is going into reverse after the massive support during the Covid lockdowns.

So the task of achieving a soft landing seems particularly challenging at present. Interest rates will still rise as they are starting from low levels – below equilibrium rate. When an economy is at full capacity this is the rate required in order to avoid either overstimulation (and possibly undue inflationary pressures) or under-stimulation (possibly resulting in economic contraction and the risk of deflation).

We are looking for a further six consecutive hikes in rates with the fed funds rate peaking at 2.25 – 2.5% early next year.

Some would see this as neutral (markets expect more tightening than us), but given the current headwinds it could end up being tight enough to cause the economy in the US to roll over. Inflation will come under control, but the price is likely to be a recession.

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