International Forecaster Weekly

THE FED HAS NEVER REDUCED INFLATION THIS HIGH WITHOUT CAUSING A RECESSION

A major study out last Friday finds that the Federal Reserve has never reduced inflation from high levels, much like today’s, without causing a recession.

The paper was written by a group of leading economists, with three current Fed officials addressing its conclusions at a conference on monetary policy.

When inflation takes off, as it has over the past two years, the Fed normally reacts by raising interest rates – sometimes forcefully – to try to put the brakes on price increases and cool the economy in the process. 

The higher rates, directly or indirectly, make mortgages, car loans, credit card debt and commercial lending more expensive.

But sometimes – again, like today – inflation remains stubbornly high, requiring even higher rates to rein it in. 

Guest Writer | March 1, 2023

By Dave Allen for Discount Gold & Silver

A major study out last Friday finds that the Federal Reserve has never reduced inflation from high levels, much like today’s, without causing a recession.

The paper was written by a group of leading economists, with three current Fed officials addressing its conclusions at a conference on monetary policy.

When inflation takes off, as it has over the past two years, the Fed normally reacts by raising interest rates – sometimes forcefully – to try to put the brakes on price increases and cool the economy in the process. 

The higher rates, directly or indirectly, make mortgages, car loans, credit card debt and commercial lending more expensive.

But sometimes – again, like today – inflation remains stubbornly high, requiring even higher rates to rein it in. 

The result is increasingly more expensive loans, which Chris Rugaber says can force companies “to cancel new ventures and cut jobs and consumers to reduce spending. It all adds up to a recipe for recession.”

And that, the paper concludes, is just what has happened in previous periods of high inflation. 

The co-authors reviewed 16 episodes over the last 73 years when the Fed and/or other central banks raised rates to fight inflation in the U.S., Canada, Germany and the UK. 

Their finding: In each and every (emphasis mine) case, a recession resulted.

The paper says, “There is no post-1950 precedent for a sizable... disinflation that does not entail substantial economic sacrifice or recession.”

The paper was written by Brandeis University economics professor Stephen Cecchetti; chief JPMorgan Chase economist Michael Feroli; Peter Hooper, a vice chair at Deutsche Bank, and former Fed governor Frederic Mishkin.

Its release coincides with a growing feeling among Wall Street, economists and investors that the Fed will likely have to boost interest rates higher than previously estimated. 

Over the past year, the Fed has raised its benchmark short-term Fed funds rate eight times – from a starting range last March of 0%-0.25% to its current level of 4.5%-4.75%.

The view that the Fed will keep raising rates was underpinned by the Labor Department’s report last Friday, showing the Fed’s preferred inflation gauge (the PCE) picked up in January after several months of declines. 

Prices jumped 0.6% from December to January, the biggest monthly increase since last June, making it more likely that the Fed will need to do more to bring inflation down closer to its 2% target.

Past Is Not Prologue

Yet, Philip Jefferson, a newer member of the Fed’s Board of Governors, suggested on Friday that a recession may not be inevitable – sharing a view previously expressed by Fed Chair Jerome Powell. 

According to Rugaber, Jefferson downplayed the role of past episodes of inflation, noting “the pandemic so disrupted the economy that historical patterns are less reliable as a guide this time.”

“History is useful,” Jefferson said, “but it can only tell us so much, particularly in situations without historical precedent.” The current situation is different, he added, from past episodes in at least four ways:

*      The “unprecedented” disruption to supply chains since the pandemic; 

*      The decline in the number of people working or looking for work; 

*      The Fed has more credibility as an inflation-fighter than in the 1970s; and 

*      The Fed has moved urgently and powerfully to fight inflation with eight rate hikes in the past year.

And now, a majority of the nation’s business economists expect a recession to hit the U.S. this year – although later than they had previously forecast.

That delayed optimism comes after a series of government reports have pointed to a surprisingly resilient economy despite interest rates that are four and a half percentage points higher than a year ago.

58% of the economists responding to the National Association for Business Economics survey see a recession sometime this year, the same as in NABE’s December survey. 

But only a quarter of them think a recession will have begun by the end of March, only half the number who had thought that in December.

Roughly one-third of the economists now expect a recession to begin in the 2ndquarter, while 20% believe it will start in the 3rd.

In January, the government reported that employers added 517,000 jobs, and the (undercounted) headline unemployment rate reached a 54-year low of 3.4%. 

(The Labor Department’s more encompassing U-6 rate, which includes discouraged job seekers and those working part-time for economic reasons, is almost twice the headline level at 6.6%.)

Plus, retail sales at stores and restaurants jumped 3% last month, the highest monthly gain in almost two years – suggesting that consumers, who drive most of our economy, still feel their financial mojo and a willingness to spend despite all the uncertainty out there.

Meanwhile, more than one government reports also showed that inflation shot back up in January after weakening for several months.

And that’s fanning fears once again that the Fed will raise its funds rate even higher and more often than was previously expected. 

As of the end of trading today, traders in Fed futures see a 76% probability of another 25-basis point hike in March and a 24% probability of 50 bps.

Traders see a nearly 75% probability that Fed rates will peak at 5.25%-5.5% by December – implying a total of three more 25 bp increases between now and then.

It’s the resulting tighter credit that can then weaken the economy and cause a recession. 

Whether those coming hikes will cause a soft landing or a hard landing and recession – and to what extent – remains to be seen in the coming months.