What if the Fed’s own forecast is wrong?

The projections by the Fed governor will always paint a rosy picture. They’re ordered to state their views on the optimal monetary policy, which obviously makes better results achievable. In the real world, as evidenced in the past year, policies are often far from that ideal, so the actual results will usually be worse than the forecasts suggest.

In the same vein, the fed model that underpins its staff forecast contains assumptions that contribute to more attractive forecasts. They include that the Fed will pursue the optimal monetary policy path in the future (regardless of past mistakes) and that households and businesses know this.

This assumption excludes persistent monetary policy errors or loss of confidence by households and businesses in the Fed’s commitment and ability to achieve its employment and inflation goals.

The Fed also operates in a world where there is an important political economic constraint. Admitting that a recession will be needed to check inflation may reduce public support for tighter monetary policy. It could also expose the Fed to criticism that could ultimately undermine its independence or cause Congress to limit its authority in the future. Sugarcoating the cost of what the Fed needs to do can be seen as a necessary evil so that it can carry out its mission successfully. But it also runs the risk of undermining the Fed’s credibility.

Do I believe recession is inevitable? For starters, the Fed has committed to bringing inflation down to its 2% annual rate target. Powell explained in his remarks at the Jackson Hole conference in August that this goal is “unconditional” and reiterated his commitment in his September news conference. Failure is an unattractive option because inflation expectations will rise, necessitating harsher monetary policy and poor results. later.

To bring inflation to 2%, that is Federal Open Market The committee should push the unemployment rate significantly. The labor market is far too tight to be consistent with a stable or declining inflation rate.

Judging from the relationship between unfilled job openings and the number of unemployed people, known as the Beveridge curve, the unemployment rate consistent with stable inflation has risen considerably and may be as high as 5%, far higher than the current rate of 3.7%. . Even if the Beveridge curve moves back down because labor market frictions are abated, the unemployment rate will still need to rise to at least 4.5%.

During the post-war period, every time the unemployment rate rose by 0.5 percentage points or more, the US economy was in recession. This empirical rule is referred to as Sahm’s rule. The difficulty of engineering a soft landing is underlined by the fact that there is no example of the unemployment rate rising between 0.5 and 2 percentage points from the trough to the very peak. Once the unemployment rate has moved up modestly, it is difficult to stop. Therefore, the Fed’s Summary of Economic Projections in September in which unemployment rose to 4.4% from its recent trough of 3.5% will be unprecedented.

Powell’s cited episodes of successful soft landings—in 1965-66, 1984-85, and 1993-95—do not apply to the current set of circumstances. In that case, the Fed tightened and the economic growth slowed and the unemployment rate decreased, but in one of these episodes, the Fed did not tighten enough to push the unemployment rate up. In Fed parlance, these soft landings are achieved from above, by slowing the economy to a sustainable growth rate, instead of from below, slowing the economy and thus pushing the unemployment rate up.

The Fed’s risk management will also increase the likelihood of a recession. Powell has explained that the consequences of failing to bring inflation back down to 2% on a sustainable basis is unacceptable. The lesson of the 1970s was that failure would lead to unfettered inflationary expectations, making the job of restoring price stability more difficult.

In addition to that eatTask ‘s will be difficult with uncertainty about whether it has been done enough. How high should short-term interest rates go to push the unemployment rate above a level consistent with stable inflation? How long would such an unemployment rate need to increase to reduce inflation back to 2%? Since, at the margin, the negative consequences of doing too little outweigh the negative consequences of doing too much, this means that monetary policy is likely to ultimately be kept too tight for too long. The long and variable lags between changes in monetary policy stance and its effect on economic activity reinforce this.

Some argue-including Fed officials-that a soft landing is still possible:• As supply chain disruptions dissipate and the allocation of demand between goods and services normalizes, headline inflation will drop sharply.• Labor supply will increase as labor force participation increases.• Fed tightening can reduce excess demand for labor without generating a large increase in unemployment.

Although one can not dismiss this point out of hand, I am afraid they are likely to prove enough to avoid a hard landing.

First, even if the drop in the price of goods causes headline inflation to drop sharply in the next year, it does not deal with the fact that the problem of inflation has broadened out, to the price of services and wages.

The breadth of inflation pressure is visible in the median consumer price index calculated by the Federal Reserve Bank of Cleveland and the trimmed personal consumption expenditure deflator – an alternative measure of inflation calculated by the Federal Reserve Bank of Dallas – with an increase of 7% and 4.7. %, each in the past year. Those numbers capture what happened to those goods and services at the center of the inflationary distribution.

Similarly, the trend of wage inflation is also high at a consistent rate with 2% inflation. For example, the employment cost index for wages and salaries of private industry workers has increased by 5.2% over the past year, and Federal Reserve Bank of Atlanta’s wage tracker index rose at an annual rate of 6.4%. Given labor productivity trends, wage inflation should be in the 3% to 4% range to be consistent with the Fed’s 2% inflation goal.

Second, on the labor supply front, the Fed is unlikely to be exempt from large increases in labor force participation. As labor economist Stephanie Aaronson noted in her remarks at this year’s Jackson Hole Fed conference: “The unemployment rate is the best gauge of the state of the business cycle.” Although a tight labor market can be expected to provoke an increase in labor force participation. , he said, the process is slow-moving, playing out over several years, too slow a process to save the Fed.

Third, the notion that Fed monetary policy tightening can be oriented toward reducing excess labor demand without materially causing unemployment is wishful thinking. Monetary policy cannot be targeted in such a way as to reduce labor demand in industries where demand is excessive relative to industries where labor supply and demand are in better balance. It is an obscure tool that affects the economy broadly through its influence on financial conditions.

Although a soft landing would obviously be better, the ship has sailed. Today, recession is almost inevitable.

This story has been published from the wire agency feed without modification to the text.

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