U.S. RISKS DEEPER DOWNTURN IF FED HAS TO FIGHT INFLATION ALONE / THE WALL STREET JOURNAL

U.S. Risks Deeper Downturn If Fed Has to Fight Inflation Alone

Steps to make economy more resilient to shocks, particularly from energy, could ease the threat of severe recession

By Nick Timiraos

Federal Reserve officials are expected to again raise interest rates by 0.75 percentage point on Wednesday. / PHOTO: AL DRAGO/BLOOMBERG NEWS

After the 2008 financial crisis, the U.S. relied heavily on the Federal Reserve to stimulate growth, leading to a frequent quip that monetary policy had become the “only game in town.”

Now, high inflation is fanning fears this is true again but in the opposite direction: Washington risks relying excessively on the Fed to lower inflation by reducing demand rather than have other policy makers work to increase the economy’s capacity to supply more goods and services or workers.

The danger is the Fed will raise interest rates higher for longer than otherwise, creating a deeper downturn.

Inflation has soared because supply and demand are out of whack. 

Demand surged after the economy’s reopening and aggressive government stimulus. 

Later, Russia’s invasion of Ukraine aggravated supply-chain disruptions and drove up energy and commodity prices.

The White House says combating inflation is primarily the Fed’s responsibility but that it will act to reduce prices where possible. 

For example, it has called for allowing Medicare to negotiate prescription drug prices. 

A separate bill before Congress would boost the domestic production of microprocessors.

Fed officials, meanwhile, have indicated that if forced to choose between bringing down inflation or preventing a recession, they would select the former. 

“Our mandate says, ‘price stability.’ 

It doesn’t say, ‘price stability unless Putin invades Ukraine,’” Fed governor Christopher Waller said recently.

Fed officials are expected to raise interest rates Wednesday by 0.75 percentage point, which would bring their benchmark rate to a range between 2.25% and 2.5%.

Rate increases slow the economy and cool inflation by reducing asset prices and raising borrowing costs, which damps investment, hiring and spending. 

Higher rates can’t fix supply-chain bottlenecks or increase oil production or refining capacity, and more expensive borrowing threatens to worsen some of those constraints by deterring new investment.

Fed Chairman Jerome Powell said last month he worried governments were relying too much on monetary policy. 

“There’s much too much focus on demand management and not enough on things that will make us grow at the maximum sustainable level,” he said.

Steps to improve the supply side of the economy are unlikely to lower inflation in the near term, but they could help the Fed in the coming years if the economy has changed in ways that create more inflationary pressures—for example, if labor shortages persist as the workforce ages and immigration slumps.

“We have all woken up to the fact that there is a supply side out here, and it needs some attention—but only belatedly and not anywhere near the attention it’s going to need,” said John Cochrane, an economist at the Hoover Institution.

Fed officials, analysts and policy advocates have suggested options for addressing the problems, with each bringing trade-offs.

Policies to boost legal immigration or workforce participation and to make the U.S. less reliant on foreign energy are “all levers that would be useful right now,” said Richmond Fed President Tom Barkin in a recent interview.

One big inflation risk is a possible further run-up in the prices of petroleum products. While commodity prices have retreated over the last month amid investors’ fears of a global recession, analysts at Goldman Sachs expect them to rise later this year because inventories are at record lows and producers have little spare capacity.

This could lead to a cycle in which prices rise, causing the Fed to raise rates more to curtail demand, creating a downturn with less capital investment by commodity producers. 

“Recessions never lead to higher capex investment, which means you’re creating a persistent supply shortage,” said Damien Courvalin, head of energy research at Goldman Sachs.

Employ America, a research and advocacy group focused on strengthening the labor market, says the U.S. government should use the Strategic Petroleum Reserve’s exchange authority to put a floor under the price of U.S. crude oil and separately finance the drilling of new wells. 

That would give American producers more reason to invest without fear that economic downturns or price wars between oil-producing nations would bankrupt them.

“The White House is going to have to treat this like the crisis that it is if they want to avoid a recession,” said Skanda Amarnath, executive director of Employ America.

Mr. Courvalin said programs to subsidize energy production could mimic existing federal crop insurance that protects farmers against declines in commodity prices. 

To ease concerns about undercutting steps to address climate change, officials could pair that investment with more spending on renewable energy development.

Others point to help from regulatory policy. 

Philip Verleger, an energy economist, has for years warned that diesel prices would rise after an international standard took effect two years ago to reduce the sulfur content in marine fuels. 

“The environmentalists would scream, but backing off on this rule would make a big difference right now” by bringing down diesel fuel and shipping costs, he said.

Finally, fiscal policy can, at a minimum, avoid adding to inflation, economists say. Several states have enacted or are considering inflation rebates or tax refunds. 

“Giving money to people to pay their higher gas prices is not going to help,” said Mr. Cochrane at the Hoover Institution.

A bolder supply-side focus might still be insufficient to bring down inflation while avoiding a recession—a so-called soft landing. 

“The lesson of the 1970s is that the Fed is in charge of inflation, and the Fed can’t flinch,” said Stephen Cecchetti, an economist at Brandeis University.

But the landing could be harder if the Fed has to destroy more demand because the economy isn’t able to supply workers, goods and services as easily as it did before the pandemic.