“Unless we have very surprising and positive developments,” Summers told POLITICO, “we probably won’t see the inflation rate come all the way down [the Fed’s] Destination without some level of significant economic hardship. Summers, who was also a top adviser in the Obama White House, has derided previous Fed forecasts as “delusional”.
The outcome has far-reaching implications for the country, including for countless American families, who have benefited from an exceptionally strong job market but have also struggled with historic price surges that have eroded wage increases and stretched household budgets. It also poses a tremendous challenge for the Joe Biden presidency, as a miscalculation by the Fed could result in an economic slump, persistently high inflation, or worse, both.
While the Fed saw in June that the unemployment rate would hit 4.1 percent by the end of 2024, some economists say it may need to climb to nearly 6 percent and stay there for some time to bring down inflation — a rise that will no doubt this would coincide with a recession.
Diane Swonk, chief economist at KPMG, said the issue is no longer whether the Fed can avoid a recession, but whether it will accept a modest downturn that slowly erases inflation, or a larger one that gets the job done quickly.
“The Fed’s optimal scenario is that we get there with just a modest rise in unemployment,” Swonk said. “I think there’s some recognition within the Fed that it may have to be more than that.”
Still, there are already signs that the labor market is cooling, which could ease the pressure on the Fed to continue raising rates as aggressively as it has been so far. Job vacancies fell to 10.7 million in July, the lowest level in nine months, though still a historically high. And average monthly job growth over the preceding three months stagnated to 375,000 in June, from 539,000 in the first quarter of the year. The Department of Labor will release new data on hiring on Friday morning.
More broadly, economic activity has slowed significantly. The government said last week gross domestic product fell in the second quarter after contracting in the first three months of the year, raising concerns about an impending recession.
Meanwhile, Powell is under pressure from some left-leaning economists and politicians like Sen. Elizabeth Waren (D-Mass.) who argue that the Fed’s campaign to raise interest rates will do little to quell inflation, which is largely being driven by supply shocks such as the war in Ukraine and the Covid lockdowns in China. In a Wall Street Journal op-ed last week, Warren also blasted Summers as “cheerleading” for higher interest rates and “someone who never worried about where their next paycheck was coming from.”
Other skeptics say it’s up to the Biden administration and Congress to do more to help the Fed get prices under control and avoid an economic derailment.
“A recession won’t help us fight inflation — a recession will only hurt working families,” said Sen. Sherrod Brown (D-Ohio), Chairman of the Senate Banking Committee. “We need to lower prices for workers and families and fight inflation at its source – that means fighting corporate price gouging and consolidation, expanding our housing supply and investing in our supply chains.”
Democrats are poised to move soon on a bill being negotiated by the Senate Majority Leader Chuck Schumer and Sen. Joe Manchin (DW.Va.), which they say would help ease price pressures by reducing federal budget deficits — although some forecasters estimate the impact on inflation would be small and not immediate.
According to Powell, the Fed doesn’t have the luxury of ignoring supply constraints and hoping that inflation will go down on its own. And he stressed that policymakers will not resist slower growth or a softening labor market if they keep raising interest rates.
“These are things that we expect, and we think they’re probably necessary … to get inflation back on track and eventually to get to 2 percent,” he said at a news conference last month.
How much pain will it take?
Summers likened the process to an addict going through a detox — it will involve some withdrawal symptoms. For now, the Fed still expects these symptoms to be mild, although Powell acknowledges that the road to avoiding a recession has narrowed.
In June, Fed officials forecast that inflation would fall to just above its 2% target by the end of 2024 from an estimated 5.2% at the end of this year. At the same time, they expected the unemployment rate to rise just half a point, to 4.1 percent from 3.6 percent in June.
Some of their optimism reflects a view among officials that a drop in job vacancies could take some heat out of the labor market and help ease price pressures without raising unemployment sharply.
When the economy slows, employers typically back off from hiring and start laying off employees. But with so many vacancies relative to the supply of available labor, Fed officials expect a drop in job openings won’t necessarily be matched by as large a rise in the unemployment rate this time around.
Not everyone is convinced.
In a paper last month, former International Monetary Fund chief economist Olivier Blanchard, Harvard research fellow Alex Domash and Summers said the Fed’s hope is “contradictory in the face of theoretical and empirical evidence.” Looking back at labor market data since the 1950s, there has never been an example where job vacancies have fallen significantly without a significant rise in unemployment, they wrote.
“Fighting inflation requires a drop in job vacancies and a rise in unemployment,” they wrote. “There is no magic tool.”
In addition, the so-called natural unemployment rate — the rate at which economists believe unemployment leads to higher inflation — is much higher than before the pandemic, they argued. That means the job market is even tighter than many realize, and the unemployment rate must rise much more than the Fed expects to bring inflation down, they wrote.
Fed Economist Andrew Figura and Gov. Chris Waller backtracked in a blog post on Friday, saying a soft landing was still possible. They acknowledged that “it would be unprecedented if job vacancies decreased by a large amount without the economy going into recession,” but said it was an unprecedented situation.
The problem is that the Fed doesn’t have precise tools to target a specific job vacancy rate or unemployment rate to slow the economy just enough to bring down inflation. And it doesn’t have a “recession” button to press even if it wanted to.
That increases the risk that the central bank will hike rates too high, leading to a painful contraction and possibly cutting inflation too far, said economist Wendy Edelberg, director of the Hamilton Project at the Brookings Institution.
The bigger concern, she added, is that the economy will slow and inflation will remain high. That could happen if inflation expectations start to rise or if supply shocks continue to hit the economy.
It’s still possible that a recession won’t be necessary if supply constraints ease, said Claudia Sahm, a former Fed economist. “If we don’t solve supply problems, we must ensure that consumers restrain their spending,” she said. “Growth must slow down, business investment is slowing down. It just needs to get a little less hot.”
But ultimately, the Fed wants to see inflation fall — and it’s up to Powell and his colleagues to decide how quickly they want to see that.
“If they want 2 percent and they want it now, they can get it,” she said. “But to get it, we would need a recession.”