When the Federal Reserve released its semi-annual report on monetary policy to Congress last Friday, one word stood out in the 70-odd-page document.
The US central bank’s commitment to restoring price stability was “unconditional”, policymakers wrote, in their most emphatic pledge to date to tackle the most acute inflation problem in roughly 40 years.
While that promise eliminated any doubt of the Fed’s overarching priorities, it also suggested that some of the historic economic recovery since the depths of the pandemic might now need to be sacrificed in order to fulfil that goal.
Fed chair Jay Powell will have to contend with these queries on Wednesday, when he faces US lawmakers for the first of two congressional hearings on the state of the economy and how the Fed seeks to accomplish its dual mandate of stable prices and maximum employment.
His testimony comes at a watershed moment not only for the US central bank — which last week markedly stepped up its efforts to quell soaring prices by implementing the biggest interest rate increase since 1994 — but also the White House, which is trying to manage expectations of a slowdown in growth and the labour market heading into November’s midterm elections and beyond.
“There’s nothing inevitable about a recession,” US president Joe Biden told reporters this week, echoing language used by Janet Yellen, the US Treasury secretary, and Brian Deese, the director of the National Economic Council.
Biden’s remarks followed a conversation with former Treasury secretary Lawrence Summers, who criticised the president’s stimulus plan last year as well as Fed policy for stoking inflation, and is now raising red flags about the economic pain that it might take to successfully fight high prices.
“We need five years of unemployment above 5 per cent to contain inflation — in other words, we need two years of 7.5 per cent unemployment, or five years of 6 per cent unemployment, or one year of 10 per cent unemployment,” Summers warned on Monday. “There are numbers that are remarkably discouraging relative to the [Fed] view.”
Compared to March’s forecasts, which many economists billed as “wishful thinking”, the latest individual projections published by the Fed last week more explicitly acknowledged that an economic slowdown will be necessary in order to bring down inflation. But importantly, they stopped short of suggesting efforts to cool the economy will lead to a recession.
Most officials now project the benchmark policy rate to peak at roughly 3.75 per cent by the end of next year, with core inflation slowing from its 4.9 per cent annual pace, as of April, to 2.7 per cent in 2023. The unemployment rate is still only set to rise 0.03 percentage points to 3.9 per cent at that point, before eventually reaching 4.1 per cent in 2024.
That is a step up from the 3.6 per cent level forecast three months ago, but still a conservative estimate, economists warn.
“[The Fed] have a daunting task ahead of them,” said Karen Dynan, an economics professor at Harvard University, who previously worked at the central bank. “The experience of the past year really raises questions about whether such a large retreat [in inflation] is realistic without more pain.”
Powell has only gone so far as to concede that the path to achieving a so-called soft landing has become more challenging, especially as external forces — such as the commodity price surge stemming from Russia’s invasion of Ukraine and prolonged supply chain disruptions tied to Covid-19 lockdowns — have exacerbated inflationary pressures.
“What’s becoming more clear is that many factors that we don’t control are going to play a very significant role in deciding whether that’s possible or not,” he said at a press conference last week, stressing that until there is “compelling evidence” that inflation is coming under control, the central bank would press ahead with its aggressive approach to raising interest rates.
Fed officials have begun to lay the groundwork for at least one more 0.75 percentage point rate rise at their next meeting in July, with market participants girding for even further tightening. This is based on the expectation that the inflation data over the coming months will not improve at a pace that would warrant any easing up from the central bank.
According to estimates published by the Fed on Friday, which are purely based on theoretical policy rules the central bank uses as guideposts but does not “mechanically” follow, interest rates should be between 4 and 7 per cent given the current economic backdrop.