Forget soft landings – how much of a recession is needed to tame inflation?
Since the last interest rate move by the US Federal Reserve (Fed) on 27 July 2022, investors have taken a more optimistic view of when the central bank can bring monetary tightening to a close. Markets are now pricing in a “Fed pivot” in late-2023, when the central bank is expected to cut interest rates.
However, despite signs of slowdown, the likelihood of a more pessimistic outcome on policy, where interest rates have to remain higher for longer, has significantly increased in our view. The obstacle to a Fed pivot is the high level of underlying inflation and the strength of the labour market, as evidenced by the latest employment report, which showed a significant increase in payrolls and a further fall in unemployment.
An analysis of past cycles shows that it would be a rare achievement for an economy which is so late in its cycle to bring inflation back to target without a fall in activity, or an outright recession.
How much of a slowdown in activity is needed to bring inflation down?
According to the National Bureau of Economic Research (NBER), there have been nine previous occasions since 1960 where the economy has been at a peak. In each case, the economy then went into recession, before troughing out several months later. The last such contraction took place between February and April 2020 - the shortest recession on record.
Prior contractions in the US since 1960 have lasted between six and 18 months, and are more typical of what we might expect going forward. Looking at those eight cycles, the average fall in GDP was 1.6% from peak to trough and the unemployment rate rose by 2.5 percentage points (pp), moving from below to above the NAIRU (non-accelerating inflation rate of unemployment). On the CPI measure, inflation fell by 1.5 pp on average.
So far, we have seen that a significant fall in GDP has been needed to bring a major fall in inflation. From this perspective, the Fed’s projected soft landing where growth slows to just below 2% and inflation falls below 3% in 2023 looks like wishful thinking.
Greater central bank credibility and possibly lower commodity prices could help bring inflation down faster than in the past and at less cost in terms of output and employment. However, the fundamental problem remains: the US economy and much of the world is late cycle and overheating.
Monetary policy is a pretty blunt instrument in these circumstances, with central banks being forced to tighten until unemployment rises and sufficient slack is created. In our view, this would point to a fall in GDP of around 2% from peak to trough, significant and more than the current consensus of economists.
Fed should take a leaf out of the Bank of England’s book and forget the soft landing
To achieve this, the Fed will have to tighten further and take interest rates above their current view of neutral. Rates will be higher for longer, but that does not mean tightening relentlessly until unemployment is 6 or 7%, for example. The lags from higher rates to the economy mean that the Fed should proceed cautiously as the full impact is not felt for many months later. In this respect, there is scope for a Fed pivot toward the end of 2023, with rates likely to be easing as the economy falls into recession.
Although the Fed’s options are limited, it could take a leaf out of the Bank of England’s (BoE) book. The BoE has taken considerable flack for forecasting a significant recession in the UK with inflation only moving slowly toward target. However, no one could argue that they have not warned people, giving households and businesses a signal to what is ahead.
In this respect, it would be helpful if chair Jerome Powell and the Fed stopped projecting a US soft landing. A look back at history shows that such forecasts only give false hope and create a further misallocation of resources. Politically this is difficult, but the earlier households and firms can start to make the inevitable adjustments the better.
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