(Bloomberg) — Rising hopes for a soft landing for the US economy will likely hinge on whether the Federal Reserve will tolerate significantly higher inflation than desired.
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Fed Chairman Jerome Powell and his colleagues appear to be sticking to a quarter percentage point rate hike this week after pausing credit tightening last month. The goal is to slow the economy enough to get inflation down to the 2% target over time without sending the U.S. into recession—the proverbial soft landing.
The big question facing policymakers and financial markets is what happens next. Former Fed Chairman Ben Bernanke said this week’s rate hike could be the last in a central bank credit tightening campaign that has already pushed rates up by 5 percentage points.
But much will depend on how much inflation the Fed intends to accept and for how long.
Barring a recession, the labor market is expected to remain tight as demand for workers continues to outstrip supply. This will keep wages elevated and put pressure on companies to raise prices to cover additional labor costs.
“Without a recession, it would be difficult to achieve enough demand compression to take price pressures out of the system,” said Bruce Kassman, chief economist at JPMorgan Chase & Co. “Otherwise, I don’t see inflation sustaining below 3%.”
As a result, Kassman said the Fed would eventually be forced to raise rates further after this week’s hike, especially if the U.S. doesn’t slip into recession later this year, but JPMorgan’s official view is that the July rate hike will be the Fed’s last.
“There is absolutely no evidence that the Fed has done enough to wait and see,” said Lindsey Piexza, chief economist at Stifel Financial, who expects the Fed to eventually raise rates from the current 5% to 5.25% range to 6%.
different roads
Prominent economists, who warned the Fed early on about inflation, are divided on how to proceed.
Mohamed El-Erian, an economic adviser to Allianz SE, argues that the US central bank should be able to withstand around 3% inflation and not throttle the economy to bring inflation down to its 2% target.
Former Treasury Secretary Lawrence Summers has said settling on a target above 3% now is a bad idea and risks setting the stage for even stronger inflation in the next economic cycle.
What Bloomberg Economics Says…
“Several counter-supply shocks are on the horizon that could reverse the course of inflation, ultimately leading to the Fed resuming rate hikes towards the end of 2024….For now, we characterize the rate trajectory as a ‘long pause’ after July, making it more than likely that the Fed will resume rate hikes in the future.”
— American economists Anna Wong and Stuart Paul
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Inflation has fallen significantly from last year’s high. This largely reflects easing price pressures caused by the COVID-19 pandemic and Russia’s invasion of Ukraine, perhaps most notably in the oil market.
Reducing so-called last-mile inflation to 2% per annum is likely to be more difficult. That’s because it’s in the service sector, where prices tend to stay higher and where wages are a bigger part of the cost of running a business.
The Fed’s favorite measure of inflation, the Personal Consumption Expenditure Price Index, rose 3.8% in May from a year earlier. The core PCE price index (which excludes food and energy costs and which Fed officials believe is more representative of the underlying trend) rose 4.6%.
“It’s hard to go down the last mile,” said Vincent Reinhart, a former Fed official who is now chief economist at Dreyfus & Mellon Bank. “As the recession becomes more likely, the Fed will abandon its pursuit of price stability.”
Powell claims the Fed is on track to reach its 2% inflation target, but acknowledges that getting there will take time, possibly until 2025. He also acknowledges that a softening of the labor market will probably be necessary to reach the target. But he’s betting it can be done without a big rise in unemployment or a recession.
Kassman said monthly inflation could be softer in the coming months on the back of cheap imports from China, unblocked global supply chains and less rent hikes. But he argued that any bailout was likely to be short-lived due to the continued tight labor market and the willingness of companies to raise prices.
Bloomberg Opinion columnist El-Erian said the Fed is likely to have a choice in the fourth quarter: either go ahead with its efforts to bring inflation down to its target and risk breaking something in financial markets and the economy, or realize that reaching 2% will not be easy and be ready to revisit that target in the future.
Consider 3%
He argues that the Fed should aim for 3% inflation instead of 2% because of a combination of factors, including the restructuring of global supply chains and the cost of a net-zero transition.
Adam Posen, director of the Peterson Institute for International Economics, said, “If we’re going to bring the inflation rate down from 9 to 3, I don’t think we’ll lose credibility by saying we’re going to stop at 3 instead of 2.”
Summers, a paid contributor to Bloomberg TV, warned that complacency with higher inflation could cause problems down the road, as underlying forces in the economy are pushing prices higher.
“Whatever target they set is likely to be the low point of the cycle, not the average of the cycle,” he said. “Inflation is likely to rise during the economic recovery.”
“A soft landing with inflation below 3% is more likely than it used to be, but still well below 50%,” he said.
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