Fed’s full-tilt inflation fight makes a ‘softish’ landing harder to achieve

The already-slim odds of the Federal Reserve bringing down inflation without causing a painful economic downturn took another leg lower on Wednesday as the US central bank embraced what is set to be the most aggressive campaign to tighten monetary policy in decades.

After approving the largest interest rate increase since 1994 — bringing the federal funds rate to a new target range of 1.50 per cent to 1.75 per cent — the Fed signalled the policy rate could rise well above 3 per cent by year-end, reaching a level that chair Jay Powell said was expected to be “modestly restrictive” on economic activity. More rate rises are also expected in 2023.

The drastic measures reflect a heightened sense of panic that has recently enveloped the Fed as it grapples with the worst inflation in four decades and mounting evidence that the problem could get worse before it improves.

At his press conference after the decision, Powell delivered the overarching message that the central bank is “determined” to do what is necessary to address inflation, driving home the message that stifling price pressures are the number one priority even at the cost of slower growth and higher unemployment.

“The worst mistake we can make would be to fail, which is not an option,” he said. “We have to restore price stability . . . it is the bedrock of the economy.”

Economists have in turn become much more pessimistic about the economic outlook, with several on Wednesday predicting a recession could set in by next year.

“The odds of a soft landing are pretty darn close to zero, and the reason is we’re in an unprecedented environment and the Fed’s overwhelming priority is inflation, inflation, inflation,” said Stephen Kane, co-chief investment officer of fixed income at TCW.

“Inflation is a lagging indicator [and] the fact they are looking to a lagging indicator for direction as to what to do for current monetary policy that works with a 12-18 month lag, that is almost a guarantee they’ll over-tighten and cause a recession.”

Economic projections published by the Fed on Wednesday conveyed what Michael Feroli, chief US economist at JPMorgan, described as “immaculate disinflation” — in other words, that interest rates could rise enough to tame inflation without choking economic growth and causing painful job losses.

Fed officials pencilled in core inflation falling 1.60 percentage points between this year and next to 2.7 per cent, with the unemployment rate going from 3.6 per cent currently to 3.9 per cent by 2023 and 4.1 per cent by 2024. Most Fed officials now predict slower growth compared with three months ago, although the economy is still expected to expand 1.7 per cent this year and next.

Powell on Wednesday said those projections were aligned with a “softish” landing for the economy, while conceding that the path to do so had become “more challenging”.

“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, referring to the commodity price surge stemming from the war in Ukraine and prolonged supply chain disruptions that have exacerbated already-elevated inflation.

Without significant improvements on these fronts, Michelle Meyer, chief US economist at Mastercard, warned that many of the gains in the historically robust US economy and red-hot labour market may begin to erode.

“They need to start to see results in terms of a moderation in inflation, and if it goes the other direction and inflation continues to accelerate, then the Fed is in a more tricky position,” she said. “They’ll have to hike even faster and that could create more damage to the real economy.”

Powell said the Fed would need to see “compelling evidence” that inflation was coming down — specifically, a string of monthly reports showing that price pressures are consistently abating — before it was ready to pull back.

The issue with that, according to Tom Porcelli, chief US economist at RBC Capital Markets, is that future inflation prints could be even worse than the May readings that prompted the Fed to rapidly increase the pace of tightening.

“Where do you think headline prices are going within the next couple of months? They are only going higher,” he said. “If this meeting came with a 75 basis point increase and you had an 8.6 per cent inflation rate, and now it’s going to accelerate beyond where we were to 9 per cent — what do you think is going to happen in July?”

Porcelli said this dynamic could take root through to the end of the summer, meaning yet more pressure for the Fed to act aggressively through to September at the earliest.

While Powell indicated the Federal Open Market Committee was likely to choose between a 0.5 percentage points rise and a 0.75 percentage points increase at its July meeting, Julia Coronado, a former Fed economist now at MacroPolicy Perspectives, said the Fed was more likely to boost the size of its increases — even to a full percentage point — than it was to moderate.

“There’s a risk they are going to hike even more than they are saying in the [dot plot], given what Powell laid out and how trigger happy they are,” she said. “The risks of recession have definitely risen because they are not tolerating anything and they’re going to react to everything in a hawkish direction.”

Additional reporting by Eric Platt in New York

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