The Federal Reserve will likely soon learn what gymnasts already know: sticking a landing is hard.
With inflation surging to a new 40-year high and continuing to accelerate, the Fed is lifting interest rates in several planned rate hikes in 2022 as it tries to cool consumer demand and slow rising prices.
By raising interest rates, the central bank is hoping to achieve a proverbial “soft landing” for the U.S. economy, in which it’s able to tame rapid inflation without causing unemployment to rise or triggering a recession. The Fed and professional forecasters project that inflation will recede to below 3% and unemployment will remain under 4% in 2023.
Our recent research, however, suggests that engineering a soft landing is highly improbable and that there is a significant likelihood of a recession.
That’s because high inflation and low unemployment are both strong predictors of future recessions.
Inflation is fundamentally caused by too much money chasing too few goods.
In the short run, the supply of goods in the economy is more or less fixed – there is nothing that fiscal or monetary policy can do to change it – so the job of the Fed is to manage total demand in the economy so that it balances with the available supply.
When demand runs too far ahead of supply, the economy begins to overheat, and prices rise sharply. In our assessment, measures of overheating began to show in the economy throughout 2021. But a new operating framework that the Fed adopted in August 2020 prevented the Fed from taking action until sustained inflation was already apparent.
As a result, the Fed is way behind the curve. To bring down surging inflation, the Fed will now try to raise interest rates to curb consumer demand.
The resulting increase in borrowing costs can help slow economic activity by discouraging consumers and businesses from making new investments. But it would come at the risk of causing major economic disruptions and pushing the economy into a recession.
One reason the Fed’s challenge is particularly difficult today is that the labor market is unprecedentedly tight, which implies that companies need to raise wages to attract new workers.
In a sense, wages are the ultimate measure of core inflation – more than two-thirds of business costs go back to labor – so rising wages put significant upward pressure on inflation.
With wages rising so fast, there is little basis for optimism that inflation can slow to the 2% range targeted by the Fed. Our analysis shows that current wage growth implies sustained inflation above 5%.
Overall, the combination of an overheating economy, surging wages, policy delay by the Fed and recent supply shocks means that a recession in the next couple of years is certainly more likely than not.
Alex Domash is a research fellow at Harvard Kennedy School. Lawrence H. Summers is Charles W. Eliot university professor at Harvard Kennedy School. Distributed by The Associated Press.
