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The Inflation Challenge
A U.S. recession seems inevitable, but if the Fed resists political pressure to lower interest rates too soon, it can avert more serious long-term crises
By Thomas Hoenig
The U.S. economy is in turmoil. Price inflation, measured by the Consumer Price Index, exceeded 9% this past June and for September was 8.2%, well above the Federal Reserve Open Market Committee’s (FOMC) 2% target. In response, the FOMC has set in motion actions that will take the economy and the financial system down a rough tightening path. Interest rate increases will dominate the headlines, but the simultaneous withdrawal of bank reserves (quantitative tightening) will add further downside risks.
The FOMC is attempting to return inflation to its 2% target quickly; however, its delay in moderating policy in 2021 has made that goal more difficult to achieve. With inflation above 8%, the FOMC is projecting it may raise its policy interest rate to 4.6% by the end of the year, and it may need to raise the rate further in 2023 to meet its goal. If so, the chances of a U.S. recession and greater financial volatility increase substantially, which will test the FOMC’s resolve as the public, Congress and the White House demand a reversal of the committee’s policy before it reaches its goal.
Following the great financial crisis of 2008, the FOMC was intent on accelerating economic recovery. In 2010 it formally introduced quantitative easing (QE)—unrestrained money creation—as a standard tool of policy. Any threatened economic slowdown or financial disruption caused the FOMC to intervene using QE. In 2010 the FOMC committed to add $600 billion of reserves into the banking system; in 2012 it began adding $40 billion in reserves per month, quickly raising the number to $84 billion per month and continuing do so through 2013. Then again, in September 2019 as the financial system experienced renewed liquidity stress, the FOMC began adding reserves at a rate of $60 billion per month. Thus, between November 2010 and March 2020 the Federal Reserve’s balance sheet increased from less than $2.5 trillion to $4.1 trillion.
Beginning in March 2020, the FOMC took QE to a new level as it supported the government’s efforts to address the devastating financial effects of the pandemic. In that year, government spending increased 50% to approximately $6.5 trillion and remained there through fiscal year 2021. Even as the pandemic receded in fiscal year 2022, federal expenditures remained 30% above the 2019 level. The FOMC provided much of the funding for these expenditures, purchasing Treasury and mortgage-backed securities and increasing bank reserves on average by more than $120 billion per month through December 2021, adding smaller amounts through March 2022. Thus, during this period the FOMC used QE to increase the Federal Reserve’s balance sheet from approximately $4.1 trillion to just under $9 trillion, while also keeping its policy rate below 0.25%.
In the wake of these actions over the 2010-2022 period, there was a systematic increase in U.S leverage, asset inflation and most recently price inflation, while economic productivity, wages and salaries fell behind.
Gross U.S. federal debt, which was approximately $13.5 trillion and 88% of GDP in 2010, is now $31 trillion and near 125% of GDP.
Total debt of the nonfinancial sector, which was 247% in 2010, now exceeds 262%.
Between 2010 and 2018, U.S. private nonfarm business labor productivity increased at an average annual rate of 1.1%, a noticeable contrast to its 2.3% average annual rate between 1992 and 2000, a period that also followed a recession.
Between 2010 and 2018, the change in median weekly real earnings for wage and salary workers was a third less than for the 1992-2000 period.
In contrast, the Dow Jones Industrial Average, which was 11,500 at the end of 2010, increased to 36,000 by the end of 2021.
The median price of a home was $174,000 in 2010 but exceeded $350,000 at the end of 2021.
In 2022, following the government’s explosive spending and a new round of QE, inflation exceeded 9% at its peak.
Now, with the outbreak of price inflation and its adverse effects on the economy, the FOMC is finally tightening policy to return inflation to 2%. The path forward, however, will be rugged as inflation appears more entrenched, fiscal policy may add to ongoing inflationary pressures and money is becoming less abundant.
Fiscal vs. Monetary Policy
Fiscal policy, even with the expiration of spending related to COVID, will be of little help in curbing the nation’s inflation problem. While the federal deficit declined in fiscal year 2022 and may decline further in the current year, spending will remain well above pre-pandemic levels, and the federal debt will again increase as federal spending necessarily accelerates. Entitlements, for example, which make up approximately two-thirds of the government’s spending, are indexed to inflation and will add significantly to expenditures. Congress has approved programs to improve national infrastructure, expand healthcare benefits and provide subsidies to address climate change and achieve other goals. Defense expenditures will increase as military threats to U.S. interests increase. Finally, the government’s interest on debt, which was approximately $375 billion in 2019, will more than double over the next couple years; it is on its way to exceed $1 trillion as interest rates rise. Thus, fiscal policy, as currently structured and with the national debt at $31 trillion and growing, will be of little help in containing inflation.
By default, then, monetary policy must address the nation’s inflation problem. Since March, the FOMC has increased the federal funds rate to 3% and is forecasting that rate to be 4.5% by year’s end. It has also begun to shrink its balance sheet by $95 billion per month, which would pull nearly a trillion dollars of liquidity out of the economy within a year. These actions will significantly slow the economy and raise the specter of a recession and possibly a financial crisis. The extent of the policy effect is unknowable because it comes with a lag of six to 18 months or more.
Given these conditions, the best-case scenario is that the FOMC’s policy projected through year’s end causes only a mild recession during the first half of 2023 and puts price inflation on a steady downward path toward its 2% target in 2024. Unemployment would increase, but given its low starting point, it could still stay below 6% through the policy cycle. In addition, if the recession is mild, the FOMC’s quantitative tightening program should not undermine confidence within the financial industry. Under this path, the FOMC could claim policy success during 2023 and speak of a less restrictive policy rate for 2024, eventually implementing its estimated neutral rate of 2 to 2.5% in late 2024 or 2025.
While such a path is possible, it has its challenges. Consumer Price Index inflation is above 8%. Core Consumer Price Index, which subtracts food and energy prices from the measure, is now 6.6%, and both measures appear more entrenched in the economy than originally assumed. Also, while low unemployment is an FOMC goal, the combination of high inflation and low unemployment would place upward pressure on wage costs, which flow through to prices, further aggravating the inflation problem. Under these conditions, interest rates might need to increase above 4.5%, to a range of 5 to 6%, to slow the economy and fully stanch inflation. The cumulative effect of such a path would be to tighten policy more than 24-fold within one year, which would significantly raise the risk of a deep recession.
Lessons from the Past
A recession will put immediate political pressure on the FOMC to loosen monetary policy well before inflation declines to 2%. This pressure also will change the discussion within the FOMC, as various members change focus from inflation concerns to unemployment and financial stability. FOMC Chair Jay Powell has pledged to pursue a tight monetary policy until inflation is brought to heel, but the FOMC also has a history of changing directions when the economy comes under pressure or when financial turbulence unsettles the market. It has no external rule to help guide its policy, which increases its tendency to bow to outside pressures.
The FOMC faced a similar dilemma during the late 1960s and 1970s. At that time, the U.S. was engaged in a war in Southeast Asia and launched several new social programs, all of which were expensive. Much of the funding for these programs was debt financed, which placed upward pressure on interest rates.
Bowing to congressional and White House pressure, the FOMC held interest rates at an artificially low level. However, at that time the U.S. was also on an international gold standard. As the economy and federal spending remained elevated, excess dollars accumulated among nations, causing them to redeem those dollars for gold. As U.S. gold reserves fell ever lower, the government decided in 1971 to abandon this standard. While that action was necessary at the time, it removed any rules-based external constraint on the FOMC’s ability to create money. It was in this sense a form of QE, giving the FOMC full discretion to create money, suppress interest rates and inflate the economy.
What followed was a persistent period of steadily higher inflation, from 4.5% in 1971 to 14% by 1980. Only then did the FOMC, under the leadership of Paul Volcker, fully address inflation. The result was a significant recession, real estate crisis, energy crisis, banking crisis and lost wealth—a deeply painful period for the U.S. economy. Looking back, it appears the FOMC eased its policy rate from an average of 8% in 1974 to 4.75% the following year, although inflation remained above 7%. Had the FOMC stayed with the higher rate longer, the recession that occurred that year would have been deeper and lasted longer; however, it most likely would have saved the economy from the crises that ultimately occurred at the start of the next decade.
The Fed has a narrow and difficult tightrope to walk. The odds are high that the U.S. will experience a recession in 2023. While the Fed would like nothing more than to return to 2% inflation and full employment without a significant recession, the odds of doing so are small. Success will depend on a steady policy and some badly needed good luck.
The U.S. has come to expect that the FOMC will keep interest rates low, fund government deficits and print whatever money is necessary to do so. Over time, these actions have invited asset inflation and now price inflation. The Fed must now reverse itself. Interest rates must rise, the economy must slow and unemployment must increase to regain control of inflation and return it to the Fed’s 2% target. There is a cost in doing this, but there is no quick fix, and the FOMC must stand firm in its resolve to take the economy through the storm.