Fed prepares to raise rates as ‘soft landing’ turns into tougher sell

Federal Reserve officials are meeting this week with one main goal in mind: to cool the economy enough to curb rapid inflation.

The odds of pulling it off without plunging the nation into recession are dwindling.

As the Fed prepares to take an aggressive stance to contain persistent inflation, likely discussing raising interest rates by three-quarters of a point this week, investors, consumers and economists are increasingly expecting that the economy could fall next week. year. Even researchers who believe the central bank can still achieve a “soft landing,” in which policymakers steer the economy onto a more sustainable path without causing a spike in unemployment and an outright contraction, acknowledge that the path towards that optimistic outcome has become narrower. .

“It was not obvious that a soft landing was feasible,” said Michael Feroli, chief US economist at JP Morgan, who still thinks it could happen. “The degree of difficulty has probably increased.”

The problem stems from US inflation data, which has become more worrying. Consumer prices accelerated in May at a pace of 8.6 percent, the fastest since 1981. Even after discounting volatile food and fuel costs, which the central bank can do little to control, the Inflation was firmer than expected last month, as rents, airfares and hotel room rates rose. Compounding the problem, two recent reports showed inflation expectations heading higher.

The data suggests the Fed may need to act more decisively, further slowing consumer and business spending and the labor market, to rein in prices.

Before last week’s inflation report, central bankers were expected to raise interest rates by half a percentage point at their meeting this week and then again in July. But now the Fed is likely to discuss moving more quickly to try to quell inflationary pressures before they become a permanent feature of the economic backdrop. They could also continue to raise rates by more than their usual quarter-point increases through September or even beyond, many economists predict.

The Fed has already raised rates twice this year, a quarter point in March and a half point in May. If he takes more drastic measures — making mortgages and business loans even more expensive, stifling business expansion plans, and crippling the job market — he would increase the likelihood of unemployment and a shrinking economy.

For months, the Fed has acknowledged that the path to slower inflation is likely to be unpleasant. When the central bank raises the fed funds rate, it trickles through the economy to slow consumer and business demand, eventually weighing on wages and prices. The way to control inflation is essentially to cause a little economic pain.

Still, top policymakers have expressed consistent optimism that because the US labor market was starting from a strong position, it might be possible to cool inflation without erasing recent labor market progress. With so many job offers per unemployed worker, the logic goes, it might be possible to tighten conditions enough to better balance the supply of workers with the demands of employers.

“I think we have a good chance of having a soft or soft landing,” Fed Chairman Jerome H. Powell said at his news conference after the central bank meeting in May, adding that “the economy is strong. and it’s OK”. positioned to handle tighter monetary policy.”

But someone has to feel the pressure and stop spending for Fed policy to work, and with inflation higher and stubborn, it will take more pressure on demand to adjust.

In fact, said JP Morgan’s Feroli, the Fed’s economic projections, to be released for the first time since March after this meeting, could show a marked slowdown in growth and a rise in the unemployment rate to illustrate that policymakers of policies are serious. about controlling the economy and controlling prices. Unemployment is now at 3.6 percent, which is below the 4 percent level that Fed officials believe a healthy economy can sustain in the long term.

If the Fed has to drastically slow the economy, it will be a challenge to do so without causing a recession. For one thing, when unemployment rises, recession tends to follow. Recessions have occurred when the unemployment rate rose by 0.5 percentage point above its recent low on average over a three-month period, a relationship called the Sahm Rule, after economist Claudia Sahm.

On the other hand, interest rates are a blunt tool and work late, and the Fed may simply overdo it.

Investors fear a bad result. Stocks plunged into a bear market on Monday, meaning their value fell rapidly by 20 percent, as investors fret that the central bank is about to trigger a recession in its quest to rein in inflation. .

“People think the soft landing is a dream,” said Priya Misra, director of global rates strategy at TD Securities. “That’s the big picture.”

It’s not just Wall Street that is getting gloomier. Consumer confidence fell to its lowest level on record in preliminary data from the University of Michigan survey, and expectations of higher unemployment in a New York Fed survey have been picking up.

Even if the Fed is also becoming increasingly uncertain about its chances of making the economy slow smoothly, Powell may not say that. Coming from a senior central bank official, a prediction that the economy is headed for tough times could become a self-fulfilling prophecy, shattering already fragile confidence.

“They went from soft to soft; I don’t think there’s another term they can use to say ‘it’s not a complete disaster,’” Misra said. “I think the markets are fooling themselves, that they won’t be able to do it.”

A recession would spell trouble for the White House. President Biden has made sure to emphasize that the Fed is independent and that he will respect its ability to do what it deems necessary to rein in inflation, even as its approval ratings plummet and the economy heads into a potentially difficult transition period.

“The Federal Reserve bears the primary responsibility for controlling inflation,” Biden wrote in a recent op-ed. He added that “previous presidents have tried to influence their decisions inappropriately during periods of high inflation. I will not do this.

Still, some have argued that the central bank shouldn’t be the only one in town when it comes to reining in inflation, given the pain its policies inflict. Skanda Amarnath, executive director of the employment advocacy group Employ America, argued that the White House should take more aggressive steps to improve gas supplies, for example, to try to offset inflationary pressures.

Trying to stifle them by stifling demand, which the Fed can do, comes at too high a cost, he argued.

“If you are going to rely solely on the Fed to solve this problem, the outlook is not good,” he said.

But most leading economists see the Fed as the key solution to inflation, just as it was when Paul Volcker ran it during the 1980s. He raised interest rates to punitive, recession-inducing levels to drive down interest rates. prices that had taken off during the 1970s. That is why many expect a big move on Wednesday.

A three-quarter point move “would underscore his commitment to avoiding the mistakes of the 1970s,” said Diane Swonk, chief economist at Grant Thornton. “Now they are trying to bring inflation down and keep it down in a more inflation-prone world.”

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