For the Federal Reserve (Fed) to make the unlikely policy pivot that would reduce inflation back to target and stave off an outright recession would be a “rare achievement”, says chief economist and strategist Keith Wade of Schroders, a multinational asset management firm.
Although investors have taken a more “optimistic view” of when the central bank can bring monetary tightening to a close since the last interest rate move by the Fed on July 27, with markets now pricing in a “Fed pivot” in late 2023 when the central bank is expected to cut interest rates, Wade believes interest rates are likely to remain higher for longer.
This investor perspective comes off the back of the Fed chair Jerome Powell stating that US interest rates are now “neutral”, indicating that the initial adjustment from the “ultraeasy” pandemic policy is over and that future rate decisions will be taken on a meeting-by-meeting basis depending on the data — which is now showing economic cooling as retail spending and housing slow.
However, despite signs of slowdown, the likelihood of a more “pessimistic outcome” on policy, where interest rates have to remain higher for longer, has significantly increased in Wade’s view, considering historical cycles.
“The obstacle to a Fed pivot is the high level of underlying inflation and the strength of the labour market, as evidenced by the latest employment report, which showed a significant increase in payrolls and a further fall in unemployment,” he says.
Wade adds that an analysis of past cycles shows that it is a tall order for central banks to bring inflation back to target levels without a fall in activity or an outright recession so late in its cycle.
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“The rapid rebound in the US since the economy reopened from Covid restrictions last year has taken activity above its long-run trend, as evidenced by a tight labour market and high-capacity utilisation rates in the industry,” he says.
At 3.5%, the unemployment rate is well below estimates of equilibrium, or the non-accelerating inflation rate of unemployment (NAIRU), the lowest level of unemployment that can occur in the economy before inflation starts to rise. The Congressional Budget Office (CBO) has forecast this figure to hit 4.4% in the second quarter.
Meanwhile, consumer price index (CPI) inflation has risen to 9.1%, its highest level in 40 years. Relative to previous peaks since 1960, the current position compares with an average CPI inflation rate of 6.1% and an unemployment rate 0.5% below the NAIRU, notes Wade.
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He has attempted to figure out how much of a slowdown in activity is required to bring inflation down by looking back at previous peaks in the US economic cycle to gauge the effect of the subsequent contraction in output on unemployment and inflation.
According to the National Bureau of Economic Research (NBER), there have been nine previous occasions since 1960 where the economy has been at a peak. In each case, the economy then went into recession before “troughing out” several months later, with the last such contraction occurred between February and April 2020 — the shortest recession on record, says Wade.
“Prior contractions in the US since 1960 have lasted between six and 18 months and are more typical of what we might expect going forward. Looking at those eight cycles, the average fall in gross domestic product (GDP) was 1.6% from peak to trough, and the unemployment rate rose by 2.5% points, moving from below to above the NAIRU. On the CPI measure, inflation fell by 1.5% points on average,” he elaborates.
Wade concedes that the economic landscape today has changed. Short-run inflation expectations — which tend to be sensitive to the price of gasoline, have risen, but over five years, households expect inflation to be close to the target — and wage growth have picked up with the tight labour market, while medium-term price expectations remain stable.
If sustained, this bodes well for the labour market adjustment, while unemployment will not need to rise as much if wage growth is contained, Wade points out, adding that greater central bank “credibility” and possibly lower commodity prices could help bring inflation down faster than in the past and at less cost in terms of output and employment.
However, he insists that the “fundamental problem” remains: the US economy and much of the world are “late-cycle and overheating”.
“Monetary policy is a pretty blunt instrument in these circumstances, with central banks being forced to tighten until unemployment rises and sufficient slack is created. In our view, this would point to a fall in GDP of around 2% from peak to trough, less than in the Great Recession or Volcker era, but still significant and more than the current consensus of economists,” he says.
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Considering the historical context, he believes the Fed should stop projecting soft landings and instead forecast more realistic outcomes in order to help the market make the correct adjustments, such as what the Bank of England (BoE) has done.
Despite the Fed’s limited options, Wade recommends taking a “leaf out of the BoE’s book”. “The BoE has taken considerable flack for forecasting a significant recession in the UK with inflation only moving slowly toward the target. However, no one could argue that they have not warned people, giving households and businesses a signal of what is ahead,” he points out.
“In this respect, it would be helpful if chair Powell and the Fed stopped projecting a US soft landing. A history review shows that such forecasts only give false hope and create a further misallocation of resources,” adds Wade. “Politically this isn’t easy, but the earlier households and firms can start to make the inevitable adjustments, the better.”
