Look out below!
As inflation continues to cool—even pesky shelter inflation—the US Federal Reserve is facing increased pressure to begin cutting the benchmark interest rate that influences everything from mortgages to credit cards. The central bank has spent much of the past two years jacking up that rate in a bid to cool off price hikes.
After the covid-19 pandemic triggered a brief recession, a lot of things happened at once. Wallets were fat not just from government aid but also because their owners didn’t have to spend money going outside. Wages rose as people took the post-vaccine hiring boom as a chance to find better jobs or unionize the ones they already had. So-called “revenge” spending proliferated, finding its expression in maximalist fashion, for example. Supply chains that got depleted when all the factories and shipment channels had shut down suddenly roared back to life, and businesses of every sort were rushing to get back up to speed.
All of these factors came together to send prices shooting higher, with US inflation hitting almost 9% in June 2022, a level it hadn’t reached in 40 years.
The Fed’s dual mandate, as always, is bring prices back down to earth while making sure too many workers don’t lose their jobs in the process. Because the rush of people back into the job market kept unemployment at the near-record lows it had been approaching before the pandemic, Fed chair Jay Powell trained his sights solely on fighting inflation.
The major problem of monetary policy is that it’s an incredibly broad solution to what can be a set of very narrow problems. Powell cautioned that economic pain would probably accompany the rate hikes, noting that the path back to price stability was “likely to be bumpy and take some time.”
Would people lose their jobs? Probably. Would a recession happen? Maybe. But that was accepted as the cost of maintaining order in the world’s largest economy. Still, Powell held out hope that he could accomplish the central banker’s Holy Grail: a soft landing.
The Landing Hardness Scale
To explain a “soft” landing, it helps to know what a “hard” landing looks like. Back in the 1970s, inflation shot skyward after the shock of the OPEC oil embargo. The Federal Reserve responded by hiking interest rates to eye-watering levels north of 12%. (Today, rates are at 5.5%.) Though inflation did come down, the U.S. also suffered its longest post–Great Depression downturn until the Great Recession of 2008. Unemployment rose to 9%.
In contrast, a “soft” landing allows price increases to fall back to the Fed’s preferred 2% range without also seeing unemployment increase by too much. It’s happened before, as in 1984 and 1994, which is why then–Fed chairman Alan Greenspan is considered such a hero by some financial history buffs. And since the Fed stopped raising rates in September, investors have begun thinking that Powell had also achieved a soft landing.
Following Wednesday’s Federal Reserve meeting on Dec. 13, where the central bank didn’t cut interest rates but for the third month in a row didn’t raise them either, the “dot plot” charting individual Fed governors’ predictions for rates and economic growth has suggested that rate cuts could be coming as soon as next year. That was the first time since 2020’s early pandemic cuts that the Fed telegraphed easier monetary policy.
Wall Street went bananas. Interest rates on 10-year Treasury notes, where the lower the number, the better the price, are back below 4% and trending downward for the first time in years. Stocks are hitting record highs.
“Having been given an inch, market participants have, as they often do, taken a mile,” wrote economist Jonas Goltermann in a note for research firm Capital Economics. The market got so frothy that John Williams, head of the New York Fed branch, had to go on CNBC and tell everyone to simmer down.
“We aren’t really talking about rate cuts right now,” Williams said. “We’re very focused on the question in front of us, which, as chair Powell said, is, ‘Have we gotten monetary policy to sufficiently restrictive stance in order to ensure the inflation comes back down to 2 percent?’”
It’s true. Personal consumption expenditure, the inflation gauge the Fed pays particular attention to because it tracks the prices people actually pay for things instead of those offered to them, is still a full percentage point above where the central bank wants it. “Core” inflation, which strips out energy and food prices, is even further out.
Monetary policy timing is a delicate dance. Keep rates too high for too long, and economic growth becomes harder than it needs to be. Cut them too soon, and inflation starts creeping back up. Ten years ago, Wall Street freaked out when the Fed announced earlier than expected that it was going to start slowing down—not even stopping—its stimulus purchase of assets.
The so-called “Taper Tantrum” sent assets of all sorts into a tailspin, putting a damper on the recovery from the 2008–09 financial crisis. So even if the Fed doesn’t want to be bossed around by markets, sometimes it has to play ball.
“We’re aware of the risk that we would hang on too long,” Powell said Wednesday in response to a question from Bloomberg’s Michael McKee about timing. “We know that that’s a risk, and we’re very focused on not making that mistake.”