Inflation: Rising interest rates could increase US recession risk


US Federal Reserve Chairman Jerome Powell has pledged to do whatever it takes to rein in inflation, which is at a four-decade high and despite the Fed’s efforts so far to tame it. it.

It seems that doing so increasingly requires something painful that the Fed has sought to avoid: Recession.

A worse-than-expected inflation report for May – consumer prices jumped 8.6% from a year earlier, the biggest gain since 1981 – helped spur the Fed to raise its benchmark interest rate. 3/4 more points on Wednesday.

Not since 1994 has the central bank raised interest rates so much in unison. And until Friday’s nasty inflation report, traders and economists were expecting a rate hike of just half a percentage point on Wednesday. Moreover, some more bull run is coming.

The “soft landing” the Fed had hoped for — slowing inflation down to its 2% target without derailing the economy — is becoming more complicated and riskier than Powell ever bargained for. Each rate hike means higher borrowing costs for consumers and businesses. And each time borrowers will find lending rates too expensive, leading to a drop in spending that undermines confidence, job growth and overall economic vitality.

“There’s a way for us to get there,” Powell said Wednesday, referring to the soft landing. “It doesn’t get any easier. It’s getting more and more challenging.”

It’s always been tough: The Fed hasn’t managed to engineer a soft landing since the mid-1990s. And Powell’s Fed, which has been slow to recognize the depth of the inflation threat, is now having to catch up with a series of strong interest rate hikes.

They’re telling you: ‘We’re going to do whatever it takes to get inflation to 2%,’ said Simona Mocuta, chief economist at State Street Global Advisors. whatever they are willing to do. There will be a price to pay. ”

In Mocuta’s view, the current recession risk is probably 50-50.

“It’s not like there’s no way you can avoid it,” she said. “But it will be difficult to avoid it.”

The Fed itself admits that higher interest rates will do some damage, though it doesn’t anticipate a recession: On Wednesday, the Fed predicted that the economy will grow about 1.7 percent in the coming year. this year, down sharply from the 2.8% growth it had forecast in March. And it expects the average unemployment rate to remain as low as 3.7% by the end of the year.

But speaking at a news conference on Wednesday, Powell dismissed any notion that the Fed must inevitably cause a recession as prices to contain inflation.

“We’re not trying to cause a recession,” he said. “Be clear about that.”

However, economic history suggests that a dramatic, growth-killing rate increase may be necessary to eventually bring inflation under control. And typically, it’s the prescription for a recession.

Indeed, since 1955, every time inflation rose above 4% and unemployment fell below 5%, the economy fell into recession within two years, according to an article published this year. by former Treasury Secretary Lawrence Summers and his Harvard University colleague Alex. Firefly. The US unemployment rate is currently 3.6%, and inflation has been up to 8% every month since March.

Inflation in the United States, which had been under control since the early 1980s, flared up again with vengeance just over a year ago, largely as a result of the economy’s unexpectedly strong recovery after recession pandemic. This recovery took businesses by surprise and led to stock shortages, delayed deliveries – and higher prices.

US President Joe Biden’s $1.9 trillion stimulus program added heat in March 2021 to an already warming economy. So was the Fed’s decision to continue the easy money policies – keeping short-term interest rates at zero and pumping money into the economy by buying bonds – that was taken two years ago to steer the economy. overcome the pandemic.

Only three months ago did the Fed start raising interest rates. In May, Powell promised to keep raising rates until the Fed sees “clear and convincing evidence that inflation is falling.”

Meanwhile, some of the factors driving the economic recovery have disappeared. Federal relief payments are long gone. American savings, boosted by government stimulus checks, are back below pre-pandemic levels.

And inflation itself has eaten away at Americans’ purchasing power, causing them to spend less in stores and online: After adjusting for higher prices, average hourly wages fell 3% last month compared with a year earlier, the 14th consecutive decline. On Wednesday, the government reported that retail sales fell 0.3% in May, the first decline since December.

Now, the rising rate will squeeze the economy even more. Buyers of either homes and cars will incur higher borrowing costs, and some will delay or downsize their purchases. Businesses will also have to pay more when borrowing.

And there’s another by-product of the Fed’s rate hikes: The dollar is likely to rise as investors buy US Treasuries to take advantage of the higher yields. A rising dollar hurts American companies and the economy by making American products more expensive and harder to sell abroad. On the other hand, it makes imports in the United States cheaper, thus easing some of the inflationary pressures.

The US economy is still strong. The job market is booming. Employers have added an average of 545,000 jobs per month over the past year. Unemployment is near a 50-year low. And now there are about two job openings for every unemployed American.

Families are no longer in debt as they were before the 2007-2009 Great Recession. Banks and other lenders also don’t have the riskier loans they had before.

However, Robert Tipp, chief investment strategist at PGIM Fixed Income, thinks recession risks are growing, and not just due to the Fed raising interest rates. The growing fear is that inflation is so incurable that it can be conquered only through dramatic interest rate hikes that take their toll on the economy.

“Risk is growing,” said Tipp, “because the inflation numbers are rising so high, so strong.”

All of which makes the Fed’s action to curb inflation and avoid recession even more dangerous.

“It’s going to be a tight walk,” said Thomas Garretson, senior portfolio strategist at RBC Wealth Management. “It won’t be easy. ”

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