Opinion – Martin Wolf: A soft US landing is possible but unlikely

“Inflation is too high and we understand the difficulties it is causing, and we are acting energetically to bring it down. We have the tools we need and the decision it will take to restore price stability in favor of American families and businesses. “

So Jay Powell, chairman of the Federal Reserve, the central bank of the United States, began the press conference after the FOMC (Federal Open Market Committee) meeting last week. It was a servile apology. But Mario Draghi’s famous comment—”whatever it takes”—in July 2012, also sounded very similar.

What does the Fed’s renewed commitment to lowering inflation mean for the future? Powell optimistically stated that “we have a good chance of having a soft or near-soft landing”.

By this he meant that demand will catch up with supply, which in turn will be able to “lower wages and inflation without having to slow the economy and have a recession and materially increase unemployment.” He also stated that “the economy is strong, well positioned to handle the tighter monetary policy, but I will say that I anticipate this will be very challenging.”

What is most intriguing about this line of argument is not the confession that the suggested path will be hard to reach, but the belief that it will reach its destination. Would it be possible to reduce inflation to the target just by pruning the overheating of the labor market?

Some suggest it might be. Alan Blinder of Princeton University and a former vice chairman of the Fed recently commented that on at least seven of the last 11 occasions the Fed’s hardening has led to “pretty soft” landings. The difficulty with these comparisons is that inflation is now at its highest level in 40 years. Even the “core” annual inflation of consumer prices minus energy and food was 6.5% in the year to March 2022.

If one believes that it will simply unravel after modest hardening, one must think that inflation is mostly “transient.” This is highly optimistic. Crucially, the US enjoyed an exceptionally strong recovery. The increase in production last year was much stronger than in other major high-income countries.

The labor market recovery was robust, with high vacancy and exit rates and an agile return to low unemployment. Only employment rates remain slightly below previous peaks. In addition, wage growth has also been strong, as Jason Furman, former chairman of the Council of Economic Advisers, says, although it is slowing a bit.

The difficulty is that, contrary to Powell’s protests, inflation in general does not simply disappear in such a strong economy. Undoubtedly, some of the measured inflation is due to domestic and global supply constraints, discussed in detail in the President’s Economic Report last month. But this is also a way of saying that excess demand today is putting pressure on supply at home and abroad.

If Powell is right, supply constraints must at least not get worse, while companies and workers negatively affected by them must accept without complaint the reduction in real profits and incomes. But why should they?

Furman comments: “The 8.5% rise in the consumer price index in the 12 months to March is much faster than the pace of nominal wage growth, leading to the fastest declines in real wages over a year in last 40 years”. The conditions for a cost and price spiral exist today. The hope, instead, must be that the constraints on supply and the labor market are reversed, causing prices to fall and thus eliminating almost all need to recoup lost incomes.

The view that a significant recession will not be necessary to contain inflation is optimistic. But this is not the only form of optimism seen today. The other is the idea that this recession can be avoided. The difficulty here is that doing a fine-tuned deceleration will be even more difficult than it normally is. One uncertainty is that lower real incomes due to high inflation are likely to hold back demand, but how far they do depends on consumers’ willingness to spend the savings made during the Covid-induced recession.

Another, and probably more important, uncertainty is how tougher monetary policy affects financial conditions in the US and elsewhere. We must not forget that there are exceptionally high levels of dollar-denominated debt around the world.

In addition, asset prices have also reached extreme levels: US house prices (measured in the S&P/Case-Shiller National Home Price Index, deflated by the consumer price index) in February 2022 were 15% higher than before the financial crisis; and the cyclically adjusted share price/earnings ratio was higher than in any period since 1881 except the late 1990s and early 2000s.

Asset price collapses in response to monetary tightening would turbocharge Fed policy, but unpredictably. Even modest action by the Fed had big impacts: interest rates jumped and markets went into turmoil. What do we see the end of this turmoil or, as seems more likely, just the beginning?

Except for historians, it is perhaps pointless to ask how we got into this mess. Obviously, it is due in part to unpredictable shocks. But politicians have been overly optimistic about inflation. They should have started to normalize a monetary policy introduced into an extraordinary crisis when the worst was over. The Fed is pulling out the punch bowl too late.

Unfortunately, it is very likely that a recession will now be needed to keep inflation expectations in check. Furthermore, even if it turns out to be unnecessary, because inflation simply disappears, a recession can still occur, simply because even modestly tighter policy wreaks havoc in today’s fragile asset markets. But the Fed has to shore up its weakened credibility on inflation. This is the heart of the central bank’s mandate. He needs to gather his courage and do what is necessary.