CAMBRIDGE, Massachusetts: The United States Federal Reserve will likely soon learn what gymnasts already know: Sticking a landing is hard.
With inflation in the US surging to a new 40-year high and continuing to accelerate, the Fed is expected to lift interest rates by a half-percentage point at the end of its next meeting on Wednesday (May 4). It will be the second of seven planned rate hikes in 2022 – following a quarter-point increase in March – as the Fed tries to cool consumer demand and slow rising prices.
By raising interest rates, the central bank is hoping to achieve a proverbial “soft landing” for the US economy, in which it’s able to tame rapid inflation without causing unemployment to rise or triggering a recession. The Fed and professional forecasters project that inflation will recede to below 3 per cent and unemployment will remain under 4 per cent in 2023.
Our recent research, however, suggests that engineering a soft landing is highly improbable and that there is a significant likelihood of a recession in the not too distant future.
That’s because high inflation and low unemployment are both strong predictors of future recessions. In fact, since the 1950s, every time inflation has exceeded 4 per cent and unemployment has been below 5 per cent, the US economy has gone into a recession within two years.
Today, inflation is at 8.5 per cent and unemployment is at 3.6 per cent – suggesting a recession will be very hard to avert.
Inflation is fundamentally caused by too much money chasing too few goods. In the short run, the supply of goods in the economy is more or less fixed – there is nothing that fiscal or monetary policy can do to change it – so the job of the Fed is to manage total demand in the economy so that it balances with the available supply.
When demand runs too far ahead of supply, the economy begins to overheat, and prices rise sharply. In our assessment, measures of overheating – such as strong demand growth, diminishing inventories and rising wages – began to show in the economy throughout 2021.
But a new operating framework that the Fed adopted in August 2020 prevented the Fed from taking action until sustained inflation was already apparent. As a result, the Fed is way behind the curve today in responding to an overheating economy.