The chances of a smooth economic slowdown in the US depend on whether the Federal Reserve is willing to accept a significantly higher level of inflation than it would normally find acceptable.
Fed Chairman Jerome Powell and colleagues will likely raise interest rates by a quarter point this week. The goal is to slow the economy and reduce inflation to the 2% inflation target without causing a recession – a soft landing.
Policymakers and financial markets are uncertain about the future steps. Former Fed Chair Ben Bernanke suggested this rate increase could conclude the credit-tightening campaign, which raised rates by five percentage points.
But the extent of inflation the Fed is willing to tolerate, and its duration will significantly influence the outcome.
If a recession doesn’t occur, the job market will likely stay competitive, with demand surpassing supply. Consequently, elevated wages will lead companies to raise prices to cover higher labor expenses.
Eminent economists hold divergent views on Fed’s future course
Bruce Kasman, JPMorgan Chase & Co.’s chief economist, stated that achieving sufficient demand compression without a recession to alleviate price pressure is challenging. He believes inflation won’t consistently fall below 3% without such measures.
According to Kasman, inflation may show soft monthly prints in the coming months due to cheaper imports and improved supply chains. He believes rent increases will also slow down during this period.
However, the relief is expected to be temporary, given the ongoing tight labor market. Companies’ growing willingness to raise prices could also counteract the short-term alleviation.
Kasman warned that if the US avoids a recession, the Fed might need to raise rates again. JPMorgan’s official stance, however, is that the July increase will be the last.
Mohamed El-Erian advocates tolerating around 3% inflation without straining the economy to reach the 2% inflation target.
Lawrence Summers, a former Treasury Secretary, disagrees, considering accepting a 3%-plus goal risky for future price growth.
Both economists differ on how the US central bank should handle inflation.
El-Erian, a Bloomberg Opinion columnist, predicts the Fed will confront a dilemma in Q4. The choice will be between persisting with inflation reduction and risking damage to financial markets or the economy.
Alternatively, they may acknowledge the challenge of reaching the 2% inflation target and consider revisiting the goal later. The decision will require careful consideration of potential consequences and long-term objectives.
El-Erian suggests several factors, such as supply chain restructuring and transitioning to net zero emissions, warrant aiming for 3% inflation, not 2%.
US economists Anna Wong and Stuart Paul warn of potential supply shocks that may halt inflation progress. They anticipate an “extended pause” in rate trajectory post-July, but a possibility of future rate hikes.
The presence of possible adverse supply shocks could undo inflation progress, leading the Fed to resume rate hikes in late 2024.
A Bloomberg Television contributor, Summers warned against accepting a higher inflation rate, expressing concerns about potential future troubles as underlying economic forces push prices higher.
Former Fed official believes Fed might lose focus on price stability
Vincent Reinhart, former Fed official and current chief economist at Dreyfus and Mellon, stated that reaching the final stage of lowering inflation is challenging. He believes that if a recession becomes more probable, the Fed may abandon its focus on achieving price stability.
Fed Chair is Optimistic about the inflation target
Powell emphasizes the Fed’s commitment to the 2% inflation target, even if it takes until 2025. He acknowledges the need for a softer labor market to achieve the goal.
However, he believes this can be done without significant unemployment or a recession. Powell is optimistic about accomplishing the target while maintaining economic stability.
The 2% Inflation Target May be Challenging
The inflation rate has considerably decreased from its peak in the previous year. It mainly results from easing price pressures linked to the Covid-19 pandemic and Russia’s invasion of Ukraine, particularly noticeable in the oil market.
But, Achieving a 2% inflation rate in the final stretch is challenging due to the services sector’s nature. Prices are less flexible, and labor costs form a significant portion of business expenses.
In May, the Fed’s preferred inflation measure, the personal consumption expenditures price index, increased by 3.8% year-on-year. According to Fed officials, the core PCE price index, excluding food and energy costs, rose by 4.6%, representing underlying trends.
President of the Peterson Institute for International Economics, Adam Posen, believes that reducing inflation from nine to three percent doesn’t compromise credibility.
He argues that setting a target of three percent instead of two percent is reasonable.