The Fed Doesn’t Have a Playbook to Tame Inflation While Avoiding a Recession
By Lisa Beilfuss
Illustration by Lincoln AgnewThe Federal Reserve will begin reversing extraordinary pandemic-era stimulus when it meets next month.
What comes next is anyone’s guess—including central bankers’.
The stakes are as high as they’ve ever been for the U.S. central bank, which was in its infancy during the Spanish Flu pandemic of 1918, and for the economy and financial markets.
For every professional prognosticator who is sure a recession is inevitable, there’s another one predicting that the Fed can combat inflation without reversing economic growth.
The disagreement over the inevitability of a recession reflects varying views about the frequency and quantity of coming interest-rate increases; the Fed’s plans for and ramifications of shrinking its monster balance sheet after $5 trillion in emergency bond purchases; and the true state of an economy turbocharged by fiscal and monetary policy and not yet through the pandemic.
The labyrinth of scenarios for how monetary tightening is conducted and plays out is a web of trade-offs that have only gotten more unattractive as inflation surges and economic growth slows from lofty levels.
The Fed is late in removing stimulus that, with the benefit of hindsight, was far too excessive, especially in conjunction with massive fiscal aid.
The central bank’s largess might have staved off a worse recession and market correction in 2020, when the Covid pandemic first reached the U.S. in force and the economy effectively closed.
But it has contributed to an inflationary mess that is getting more painful to address.
The risks of a policy failure are big and growing, threatening job losses and market bloodshed to fight inflation, persistently higher prices to avoid recession, and, in a worst-case scenario, all of that at once.
Inflation was never going to be fully transitory—as the Fed until recently had argued—with money supply surging, extreme housing-market intervention making a jump in shelter prices inevitable, and unfavorable demographics weighing on labor supply well before the pandemic struck.
Now, inflation has gone from hot to boiling.
Consumers face double-digit price increases in everything from meat, eggs, and bread to gas, electricity, and bank checking-account fees—amounting to an extra $250 a month in expenses for the average American household, Moody’s says.
As it diminishes purchasing power and sours consumer and business confidence, inflation threatens economic and corporate earnings growth.
It is costing President Joe Biden in the polls and within his own party as he tries to salvage his economic agenda, and it is costing the Fed—guardian of financial and economic security and beacon of global central banks—credibility.
Diagnosing the current problem and preparing for monetary-policy normalization require a trip back to the financial crisis and recession of 2007-09.
“In Jay Powell’s defense, he has been handed a very hard hand to play,” says James Angel, a professor at Georgetown University’s McDonough School of Business, referring to the central-bank chairman.
“But he is a classic general fighting the last war.”
In its pandemic response, the Fed recycled that last economic war’s playbook and then juiced it, while moving further away from policy rules that long guided the central bank.
The Fed declined to comment.
Until the financial crisis, central bankers were systematic, says economist and Stanford University professor John Taylor.
The Taylor rule, which he devised in the 1990s and prescribes appropriate interest rates depending on the state of the economy, suggests that the federal-funds rate should now be over 5%, rather than a current 0% to 0.25%, and roughly double what the Fed says is the so-called terminal rate.
Taylor says the Fed’s decision to leave rates much lower than his rule prescribed helped cause the housing bubble and other financial excess behind the financial crisis, and then too-easy policy inhibited a better economic recovery.
Former Fed Chairman Ben Bernanke, who led the central bank during the last crisis and helped implement many of today’s unconventional tools, has pushed back against Taylor’s assertions.
Such rules can’t incorporate all of the relevant considerations for making policy in a complex, dynamic economy, Bernanke wrote in a 2015 Brookings Institution piece.
Past Is Prologue
Meanwhile, memories of a disappointing recovery—in which inflation undershot the Fed’s 2% target for years—motivated an overshoot this time.
The Fed overhauled its policy framework in the summer of 2020—following a 1½-year internal review and after the economy reopened from lockdowns—to seek periods of higher inflation to make up for stretches of below-target price increases.
And then, in September of that year, the central bank gave investors explicit guidance that reflected a departure from the norm: The bank said it wouldn’t raise rates until the labor market hit—versus approached—the Fed’s new, more inclusive but ambiguous assessment of maximum employment, and inflation was on track to “moderately exceed 2% for some time.”
The problem, some critics say, is that the Fed was fighting the wrong problem all along.
After all, the crisis playbook was written when the economy was due for a recession.
This time, the easy money was dropped on an economy that had been booming, with unemployment at a half-century low.
Demand wasn’t the problem, but it has become one.
Monetary policy can’t fix supply bottlenecks, but it is hard to dismiss the impact of ultra-accommodative policy on demand that has exacerbated economy-wide shortages.
The constraint on the Fed this time isn’t so much households and business but the amount of debt amassed by the government in recent decades and supercharged by the pandemic, says Georgetown’s Angel.
A record $30 trillion in public debt—up about 30% since early 2020—means that even rates topping out at 2% translate to an extra $600 billion a year in interest owed and affect future spending, he says.
That reality makes it easier to see why the central bank may have been so keen to dismiss inflation as transitory and proceed with a framework change that explicitly flipped it to a reactive, instead of proactive, institution.
Manage inflation expectations, move the target, and hope inflation cools, the logic seems to have been; if people and business owners didn’t believe that price inflation would stick, then maybe it wouldn’t.
But it did.
Gallup polling shows 8 in 10 Americans expect inflation to rise, and nearly half say increasing prices have caused hardship.
Against this backdrop, Biden’s approval rating started to slide this past summer and now sits at about 40%, data from Real Clear Politics show.
Any president prefers low interest rates, but inflation became a liability Biden couldn’t ignore.
After months of uncertainty, Biden renominated Powell in November for another term as Fed chairman; days later, Powell made an about-face on inflation, abruptly retiring the term “transitory” and conceding that inflation was indeed a problem.
Soon after, Sen. Joe Manchin (D., W.Va.) cited inflation concerns when he torpedoed Biden’s signature economic plan, a move that showed how inflation had become as much a political concern as an economic one, amplifying criticism over how the central bank has become more politicized in recent years.
In public comments, Powell has said that his policy shift had nothing to do with his renomination.
Credibility Concerns
Some economists and investors say the Fed’s credibility is in trouble. St. Louis Fed President James Bullard acknowledged those concerns in a recent CNBC interview.
“Our credibility is on the line here, and we do have to react to data,” he said.
Bullard is speaking to a multidimensional problem.
There is the growing perception that the Fed is in effect monetizing the government’s debt—meaning that money printing, as opposed to borrowing or taxes, helps finance the deficit.
There is speculation that letting inflation run hot is inflating away some of that public debt at the expense of those living on low and fixed incomes, and there is the inkling that the Fed’s posture changed when inflation started showing up in political polls.
Then there is the more fundamental issue that the Fed turned its eye away from inflation when it prioritized employment, the other side of its dual mandate.
Some investors now doubt that the central bank can and will do what is necessary to bring inflation back to 2%.
“We are beyond the point of return.
We will never be able to get rates to where they should be,” says Louis Navellier, chief investment officer at Navellier & Associates.
In contrast to the 1.75 percentage points in rate increases that much of Wall Street now expects this year, he predicts three to four hikes—not enough, he says, to sufficiently curb inflation or stop investors from seeking inflation shelter in stocks, real estate, and commodities.
He says the S&P 500 SPX-0.72% index can rise 30% this year.
Of all the moving pieces that Fed watchers must square, not to mention escalating geopolitical tensions pushing oil prices higher and ongoing pandemic uncertainty, the most consequential isn’t what happens with interest rates.
The Fed’s balance sheet, a much more complicated, opaque, and unpredictable device that central bankers would prefer to play down, is going to be the more meaningful policy tool this time.
“If monetary policy was responsible for driving inflation to these 40-year highs, it surely wasn’t the [1.5 percentage points] of rate cuts that caused it,” says David Zervos, chief market strategist at Jefferies.
“The culprit would have been the roughly $5 [trillion] in QE.”
Consider that the Fed owns about a third of both the Treasury and mortgage markets, and that its balance sheet has doubled since the pandemic’s onset to 40% of gross domestic product.
Perhaps more importantly, consider that the Fed simply doesn’t know much about the situation it has created.
There is an “element of uncertainty around the balance sheet,” Powell said at his press conference in January.
“I think we have a much better sense, frankly, of how rate increases affect financial conditions and, hence, economic conditions.
Balance sheet [policy] is still a relatively new thing for the markets and for us, so we’re less certain about that.
We will look to have that just running in the background.”
Wishful Thinking?
His hope isn’t unlike that of his predecessor, Janet Yellen, who said in 2017 that quantitative tightening would be like watching paint dry.
It wasn’t.
And strategists say the hope that QT won’t be disruptive this time is even more naive, given the size of the balance sheet and how high inflation has run.
If the Fed tries to reduce its portfolio the way it wants to, by letting bonds roll off as they mature and adjusting the amount of proceeds that get reinvested, it would take about five years to fully purge mortgage-backed securities, says Torsten Sløk, chief economist at Apollo Global Management.
The logic: Mortgage prepayments—often done via refinancing—will slow as rates rise.
Zervos says letting QE “slowly evaporate on its own,” as investors largely expect, carries the risk of a serious policy error.
“I expect the Fed will pivot hard to asset sales in the coming quarters.
Consequently, there is much less scope for an overshoot on rate rises, and much more of a risk that the balance sheet contracts quite aggressively,” he says.
At the same time, economists are struggling to model for QT.
“I can model what 100 basis points in hikes do to GDP.
But we don’t know what $100 billion in QT will do,” says Aneta Markowksa, Jefferies’ chief economist.
Some corners welcome more aggressive balance-sheet normalization.
“Our balance sheets are swollen beyond what we ever imagined,” says Sid Dinsdale, chairman of Nebraska-based Pinnacle Bancorp.
“We’ve been thinking people would put that money to work, but it hasn’t happened.
We won’t mind a liquidity drain,” he says, adding that higher loan rates won’t crimp demand, given the condition of his customers’ own balance sheets.
Dinsdale’s sentiment reflects what some economists and strategists say about ultra-accommodative monetary policy at this point restraining economic growth.
Monetary-policy tightening will be tough for markets but a net positive for the economy, says Barry Knapp, director of research at Ironsides Macroeconomics.
Consider those excess deposits that banks would lend out at higher rates and the cooling effect that tightening would have on investors who have flooded the housing market, pushing aside would-be buyers who have a much bigger multiplier effect on the economy than renters.
Depending on whom you ask, the economic data are solid, turning darker, or signaling that the Fed is about to begin tightening at a time when the economy is already flashing warning signs.
Therein lies some of the difficulty in predicting whether the Fed can achieve a so-called soft landing, historically elusive as the central bank tightens.
It is a self-imposed Catch-22, says George Goncalves, head of U.S. macro strategy, institutional client group, at Mitsubishi UFJ Financial Group.
“In the past, rate hikes were meant to be a vote of confidence.
This time, we have inflation before the economy is very solidly on its feet,” he says.
“My concern is they will be solving the policy error of overeasing in 2021 by a potentially equally damaging policy error as they arrest inflation’s rise.”
The “Fed Put”
Because inflation is so high, many strategists say the Fed doesn’t have the luxury this time of so easily backing off in response to market declines.
Given that the economy is more leveraged than ever to low rates and high stock prices, Goncalves says the so-called Fed put still exists but is far lower than investors have come to expect.
A sustained drop of 20% or more in stocks, with no clear sign of a rebound, is the one thing that can stop the Fed in its tracks, he says.
David Rosenberg, chief economist and strategist at Rosenberg Research, says he expects at the least a growth turndown where GDP slows below potential and sets up a deep inflation moderation.
He pegs the probability of a 2023 recession at 75%.
Others are more sanguine, even if a behind-the-curve Fed makes sticking the landing harder.
Ed Yardeni of Yardeni Research says the economy is in better shape than many believe and recession concerns are overblown.
He sees 1% rates by year end and says front-loaded increases, like a 0.5% March hike that Fed President Bullard is advocating, could ultimately mean less pain than a slower start.
While he recently lowered his price target for the S&P 500 this year, Yardeni still sees 10% growth from current levels and another double-digit increase next year.
It is harder than usual to predict how the impending tightening cycle transpires and how it will affect—and in turn be shaped by—the economy and financial markets.
If there is one place to watch for clues, it is the housing market.
As housing goes, so goes the economy.
How the Fed extricates itself from that market—which represents 40% of the core consumer-price index, nearly a fifth of GDP, and much of household wealth—will determine whether the Fed can realistically and sufficiently cool inflation without throwing the U.S. economy into a recession and markets into deeper corrections.
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