The Fed can raise interest rates without triggering a recession. Here’s why.

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The Federal Reserve has taken steps to correct its ultra-loose monetary policy while signaling that there is much more to come this year, writes Joseph E. Gagnon.

Karen Bleier/AFP via Getty Images

About the author: Joseph E Gagnon is a senior fellow at the Peterson Institute for International Economics and a former Federal Reserve official.

Almost all economic forecasters, including those at the Federal Reserve Board, did not see last year’s surge in inflation coming. Me and a few other economists warned in February 2021 that President Biden’s US bailout plan, coming on top of previous Covid-19 relief packages, would drive spending beyond the economy’s productive capacity and push inflation higher. Still, we did not anticipate the additional inflationary impact of new waves of Covid variants, which deterred workers from returning to work and further encouraged consumers to shift spending from services to goods, fueling inflationary shortages in semiconductors and Supply chains significantly worsened. The end result was the highest 12-month inflation rate in 40 years, nearly 6% in December 2021, based on the Fed’s preferred measure.

With inflation well above target and an unemployment rate near multi-decade lows, the Fed’s ultra-loose monetary stance is clearly inappropriate. To his credit, the Fed has taken steps to correct its mistake while signaling that there is much more to come this year. There are many historical examples of Fed tightening causing a recession, leading some observers to fear a repeat. But there are previous examples of Fed tightening where this has not been the case. There’s a good chance we’ll avoid a recession in 2022 and 2023.

The main reason the Fed is unlikely to trigger a recession is that inflation is likely to fall sharply this year regardless of the Fed’s actions. There are many factors behind the upcoming slowdown in inflation. First, Congress is not considering any more aid packages. The budget deficit narrows sharply as additional infrastructure and welfare packages will be much smaller than recent aid packages. Second, a return of consumer demand to a more normal balance between goods and services will reduce goods inflation much more than it will increase services inflation. Third, rapid investments in semiconductor fabs and other measures to reduce shortages will lower the prices of affected products such as cars. And fourth, a return to post-Omicron normalcy, if it occurs, will increase workers’ willingness and ability to return to full-time work, increasing the productive capacity of the economy. A counteracting factor is strong housing demand, which is likely to push up rental prices throughout the year.

Perhaps the most important signs of the impending fall in inflation can be seen in surveys of inflation expectations by households and professional forecasters, and in bond yields compensating for inflation. All of these measures show elevated inflation in 2022 but a sharp fall to pre-pandemic inflation levels in 2023 and beyond. Stable inflation rates over the past 30 years have anchored long-term inflation expectations, in contrast to the 1970s when the Fed’s lack of a sound policy framework pushed inflation expectations higher with every rise in prices.

The great accumulation of household savings of the last two years will support consumer spending, making a recession in 2022 extremely unlikely. Therefore, the Fed should move quickly to at least neutral policy, which would require short-term interest rates at or just above 2% and a fairly rapid outflow of the long-dated bonds it has been buying over the past two years to support economic activity. The Fed doesn’t have to go all the way in one meeting; The key is to signal that it wants to get there in the coming year as long as inflation stays above 2% and unemployment stays low. My recommendation would be to raise the Federal Funds Rate Target by 0.25 percentage points at each of the next eight meetings and announce soon that maturing bonds will be allowed off the Fed’s balance sheet as early as April, with runoffs being gradually allowed through the fall to a cap of reach $100 billion per month. That would be twice as fast as the pace of outflows following the Fed’s last asset purchase and would hasten the return to more neutral conditions in bond markets.

It is unlikely that monetary policy tightening to near neutrality in the coming year alone would result in a recession in 2023. In addition, the Fed will have plenty of opportunities to refine its monetary policy stance when new inflation and employment data are released. It is possible that a new and unforeseen shock could hit the economy in either a positive or negative direction. As always, the Fed must remain flexible and data-sensitive, and be ready to stop tightening if the economy weakens or tighten further if inflation doesn’t fall sharply over the course of 2022.

Opinions like this one are written by writers outside of the newsrooms at Barron’s and MarketWatch. They reflect the perspective and opinion of the authors. Send suggested comments and other feedback to [email protected]

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