The Federal Reserve: caught between a rock and a hard place

Inflation will only retreat to normal levels when demand and production capacity are in balance. If production capacity isn’t going to fully recover any time soon, that puts central banks in a real bind.

They can’t heal the underlying economic disease: the decline in production capacity. Interest rate rises do nothing to relax those constraints. What can central banks do? They can either deal with the symptom of that disease – inflation – by raising rates to levels high enough to force the parts of demand that are sensitive to interest rates down towards what the economy can comfortably produce now; or they can let demand stay above the level the economy has the capacity to comfortably support and live with inflation that is persistently above the 2% target. 

If they go for the first, that would mean crushing demand and pushing up unemployment. In fact, since it takes time for rate raises to take effect [4], if the Fed wanted to get inflation back to 2% within two years, that would require rate rises that cause GDP to fall by a little over 2% in total (as the High cost of quickly taming inflation chart shows). That’s 1.5% on top of the estimated 0.6% fall already seen in the first half of this year. That could push the unemployment rate past 5% - meaning up to 3 million additional people out of work.[5]

That’s a huge price to pay.

One thing is for sure: there’s no perfect outcome here. It’s either close-to-target inflation OR sustained growth. The Fed can’t have both.

As we saw this week, the Fed is responding to the politics of inflation: making a lot of noise about getting inflation down.

But it isn’t really acknowledging the economics of inflation: getting it down all the way soon would smash growth and jobs. In fact, the Fed’s most recent forecasts[6] see inflation coming down AND the economy getting back to (almost) the growth path it was on before the pandemic – see the Fed feeling optimistic chart. That’s only possible if production capacity recovers fully by the end of this year. Clearly, wishful thinking.

Nothing this week changed our view that the Fed will continue to raise rates into levels that will slow the economy yet further. We expect the Fed to realize later this year that it has done serious damage, which should prompt it to change course by early next year. Why? If it persists in its belief that inflation can come down without a recession, then it won’t see a need for further rate hikes. If it realizes that production capacity is set to remain limited for some time and only a serious recession can get inflation all the way down, we expect it to decide to live with more persistent inflation to avoid that cost. The result either way is: the Fed won’t deliver the full scale of recession that’s needed to get inflation down. And that means we’ll be living with inflation above 2% for some time to come.