Since the US Federal Reserve began jacking up interest rates in March 2022 to slow inflation, economists, policymakers and investors have been calculating and recalculating its chances of achieving a so-called soft landing — slowing the economy enough to rein in prices without triggering a sharp rise in unemployment. A year later, inflation was dropping but debates still raged over whether the Fed was likely to land safely or overshoot or undershoot the runway. Then new turbulence was added by the biggest banking crisis since 2008. While the bank failures were largely limited to the US, other central banks faced difficult choices on whether to continue, pause or reverse interest rate hikes.
1. What’s the danger of overshooting?
Recession. It’s what many economists have forecast will happen as the Fed’s most aggressive credit tightening campaign since the 1980s takes an increasing toll on the US economy. If what’s needed to squeeze inflation is too extreme — or if the Fed makes a mistake — what’s been a persistently strong labor market could finally crack, leading unemployment to rise significantly and millions of workers to lose their jobs. It’s not what Fed Chair Jerome Powell wants to see — nor Joe Biden, who’s seeking another term as president in 2024.
2. What’s the danger of undershooting?
The US ends up stuck with unacceptably elevated inflation. Many economists say that’s what happened in the 1970s when they think the Fed failed to keep interest rates high enough for long enough. Part of the problem facing the Fed and other central banks now is uncertainty over how long it will take the interest rates already in place to have their full dampening effect. That’s making it harder for them to gauge when it’s time to ease again. By April, the Fed’s favourite inflation gauge was running at 4.4%, significantly lower than the 7% reading in June 2022, but still more than double the Fed’s official inflation target of 2%. Powell has insisted that the Fed won’t end the inflation fight until it’s confident prices are headed back to the target.
3. Isn’t there a middle ground?
Yes — in fact, there are several. The most talked about is the soft landing — something the Fed has pulled off arguably once, in 1994-1995. Under then-Chair Alan Greenspan, the central bank doubled interest rates to 6% and succeeded in slowing economic growth without killing it. Then there’s what some economists call a “growth recession.” This oxymoron refers to a protracted period in which growth slows but the economy doesn’t actually contract. And in early 2023, there was talk of a “no landing,” as the economy started the year with a bang. Hiring surged, retail sales climbed and homebuilders turned more optimistic even as inflation eased. Under this scenario, growth reaccelerates after downshifting last year. In effect, the economy never really touches down. But by mid-year, the picture was complicated by explosions in the US banking system.
4. How did the banking crisis change the picture?
It made the landing even trickier. Banks were already gradually tightening lending standards before three regional institutions collapsed earlier this year. If financial jitters prompt banks to pull back more aggressively, the ensuing credit crunch could send the economy into recession.
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5. Why hasn’t inflation come down faster?
It’s in part due to the tight labor market, where unemployment is hovering around a multi-decade low. Employers are having to pay up to hire more workers or retain the ones they have. To avoid having those costs pinch their profits, they’re jacking up prices. Those higher wages are also giving households the wherewithal — at least for now — to pay those higher prices.
6. Where do things stand for other central banks?
Inflation is falling in most places but at different speeds, leaving policymakers a variety of challenges. The European Central Bank raised its deposit rate to 3.25% in May from -0.5% the previous June. (The Fed went from zero in March 2022 to 5.25%.) Inflation in the euro zone has slowed from a peak of 10.6% in October. ECB President Christine Lagarde has vowed to keep going with interest rate increases to bring inflation down to the central bank’s 2% target. In the UK, inflation was 8.7% in April, putting off the prospect of any quick end to the Bank of England’s string of rate hikes. Across Latin America, inflation began to ease, but central bank leaders said that they were moving cautiously after having raised rates to double digits. Those increases had led to conflict with political leaders, most notably Brazil’s President Luiz Inacio Lula da Silva, who criticized his central bank’s decision not to budge from the 13.75% it had set a key rate at in August 2022, even as inflation fell sharply in early 2023. – Bloomberg Quicktake
