Inflation Vs. Recession: Can the Federal Reserve Engineer A Soft Landing?
2022.04.13 12:06
April’s US unemployment rate poses some serious questions for the Federal Reserve as it would appear that one of its dual mandates (full employment) has been met, while the other (price stability) seems to be spiraling out of control.
April began with the unemployment level dropping even further to 3.6% in March. This is the lowest unemployment reading since February 2020, which came in at 3.5% on Mar. 6, just before the pandemic crash that changed everything.
US unemployment rate chart.
To put this into perspective, that 3.5% pre-pandemic level was lower than the boom before the 2008 crisis. It was also lower than before the dot-com bubble burst in the late 1990s. You have to go back to May 1969 for a lower reading.
The Rate Hikes Begin
Last month the Federal Reserve moved to raise interest rates by 25 basis points for the first time in three years, following a sharp ramp-up of hawkish rhetoric since the beginning of the year. Fed chair Jerome Powell was quoted as saying that it’s time to move “expeditiously” to combat inflation and prevent it from becoming more firmly rooted.
Market participants are now waiting to see whether a 50-basis-point hike will follow in May. The following week we had a scheduled address by St. Louis Fed president James Bullard, who said on Thursday, Apr. 7, that the Fed was behind the curve and that he sees a Fed Funds rate of 3.5% by the end of 2022.
This would mean a 50-basis-point hike at every one of the Federal Reserve’s remaining meetings this year. Bullard’s expectations are by far the most hawkish among his peers. The CME’s Fed watch tool currently offers the highest probability of a 2.75%-3% Fed Funds Rate following the upcoming December meeting.
Probabilities for future hikes.
Is A Soft Landing Possible?
The Federal Reserve is essentially trying to engineer a soft landing where inflation can be brought into balance without harming the economy. At just shy of 8%, inflation is currently running at four times the Fed’s target of 2%. How it navigates bringing inflation down without entering into recession is the unavoidable and unenviable conundrum Jerome Powell is now tasked with.
Last month he offered the possibility of a soft landing, citing the tightening cycles of 1965, 1984, and 1994 as historical examples of when this feat had been accomplished; in other words, the Fed had embarked on a tightening cycle without the economy entering into recession.
Three “Soft Landings”
It’s important to add some context to those three tightening cycles. William McChesney Martin succeeded in tightening 175 basis points between September 1965 to November 1966 despite pressure from President Lyndon B.
Johnson and accusations of Martin’s lack of patriotism while American soldiers died in Vietnam. What’s important to note about this brief episode is that by July 1967, the Fed was forced to tighten again, and this subsequent tightening cycle did lead to a recession.
Between February 1983 to August 1984, Paul Volker tightened by 315 basis points without the US economy entering into recession. Quite the opposite, this was the only tightening cycle of the three that occurred during strong GDP growth.
However, this cycle followed two closely-timed tightening cycles (January 1977-April 1980 and July 1980-January 1981), both of which caused sharp reductions in GDP. In other words, the US economy was coming out of recession.
Finally, the tightening cycle between December 1993 and April 1995, in which Alan Greenspan raised rates by 310 basis points with no reduction in growth. This event is often referred to as the perfect soft landing, but again, the context reveals how different the pressures facing Greenspan were from those Powell is currently wrestling with.
Throughout this period, inflation was more or less stable at around 3%, and the S&P 500 was trading at a fraction of what it is today.
A Question for Investors
The question on investors’ minds – particularly those who have enjoyed the post-pandemic boom in equities – is, does the Fed prefers a recession and reduction in inflation at this point over the forestalling of a recession and allowing inflation to continue? Also, if growth is shown to slow in the second half of 2022, as many analysts are forecasting, will the Fed be able to tighten into a slowdown?
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