“Unless we have a series of very surprising and positive developments,” Summers told POLITICO, “we probably won’t see inflation drop all the way until [the Fed’s] purpose without any level of meaningful economic distress.” Summers, who was also a top adviser in the Obama White House, has ridiculed previous Fed predictions.
The outcome has far-reaching implications for the country, including countless American families who have benefited from an exceptionally strong labor market, but have also struggled with historic price increases that have led to wage increases and household budgets. It also poses a huge challenge to the Joe Biden presidency, as a Fed miscalculation could lead to a runaway economy, persistently high inflation, or worse, both.
While the Fed in June saw the unemployment rate hit 4.1 percent by the end of 2024, some economists say it may need to rise to nearly 6 percent and stay there for some time to push inflation back — a rise that no doubt coincides. with a recession.
Diane Swonk, chief economist at KPMG, said the question is no longer whether the Fed can avoid a recession, but whether it will accept a mild downturn that slows inflation slowly, or a bigger one that does the job quickly.
“The Fed’s optimal scenario is that we get there with only a modest rise in unemployment,” Swonk said. “I think it’s recognized within the Fed that maybe it should be more than that.”
The Labor Department reported Friday that employers added 528,000 jobs in July, well above economists’ forecasts. Unemployment fell to 3.5 percent.
Still, broader economic activity has clearly slowed down. The government said last week that gross domestic product fell in the second quarter after falling in the first three months of the year, raising concerns about an impending recession.
Meanwhile, Powell is under pressure from some left-wing economists and politicians, such as Sen. Elizabeth Warren (D-Mass.), who argue that the Fed’s campaign to raise interest rates will do little to quell inflation driven largely by supply shocks like the war in Ukraine and Covid lockdowns in China. In a Wall Street Journal last week, Warren also called Summers a “cheerleader” for higher rates and “one who has never worried about where his next paycheck will come from.”
Other skeptics say it is up to the Biden administration and Congress to do more to help the Fed bring prices under control and avoid derailing the economy.
“A recession won’t help us tackle inflation — a recession will only hurt working families,” said Sen. Sherrod Brown (D-Ohio), chairman of the Senate Banking Committee. “We need to lower prices for workers and families and tackle inflation at the source – that means fighting price inflation and corporate consolidation, expanding our housing supply and investing in our supply chains.”
Democrats poised to pass legislation soon, negotiated by Senate majority leader Chuck Schumer and Sen. Joe Manchin (DW.Va.), which they say would help ease price pressures by reducing federal budget deficits — though some forecasters estimate the effect on inflation would be small and not materialize right away.
Powell says the Fed doesn’t have the luxury of ignoring supply constraints and hoping inflation will fall on its own. And he stressed that policymakers will not hold back slowing growth or easing the labor market if they continue to raise rates.
“Those are things we expect, and we think they’re probably needed … to get inflation back on track to 2 percent and eventually get there,” he said at a news conference last month.
How much pain will it cost?
Summers likened the process to an addict going through a detox — it will involve some withdrawal symptoms. For now, the Fed still expects those symptoms to be mild, although Powell acknowledges that the road to avoiding a recession has narrowed.
In June, Fed officials predicted that inflation would fall from an estimated 5.2 percent at the end of this year to just above their target of 2 percent by the end of 2024. At the same time, they expected the unemployment rate to rise only by half a point, from 3%. 6 percent in June to 4.1 percent.
Some of their optimism reflects officials’ view that a fall in job openings could provide some relief to the labor market and ease price pressures without driving up unemployment significantly.
As the economy slows, employers typically pull back on hiring and start laying off people. But with so many job openings relative to the supply of available workers, Fed officials expect that a drop in job openings this time around doesn’t necessarily correspond to such a large rise in the unemployment rate.
Not everyone is convinced.
In a paper last month, former chief economist of the International Monetary Fund Olivier Blanchard, Harvard researcher Alex Domash and Summers said the Fed’s hopes are “contrary to theoretical and empirical evidence.” Looking back at labor market data since the 1950s, there has never been an example where the job vacancy rate fell substantially without a significant increase in unemployment, they wrote.
Fighting inflation requires a reduction in job openings and an increase in unemployment, they wrote. “There is no magic tool.”
In addition, the so-called natural unemployment rate — the rate at which economists believe unemployment is fueling higher inflation — is much higher than it was before the pandemic, they argued. That means the job market is even tighter than many think, and unemployment will need to rise much more than the Fed expects to bring inflation down, they wrote.
Fed economist Andrew Figura and Governor Chris Waller responded back in a blog post Friday, saying a soft landing is still possible. They acknowledged that “it would be unprecedented if job vacancies fell by a significant amount without the economy slipping into recession”, but said this is an unprecedented situation.
The problem is, the Fed doesn’t have precise tools to target a particular vacancy rate or unemployment rate to slow the economy down just enough to lower inflation. And it doesn’t have a “recession” button it can press even if it wanted to.
That raises the risk of the central bank raising interest rates too high, causing a painful contraction and potentially pushing inflation down too much, said economist Wendy Edelberg, director of the Hamilton Project at the Brookings Institution.
The bigger concern, she added, is that the economy is slowing and inflation remains high. That could happen if inflation expectations start to rise, or if supply shocks continue to affect the economy.
It’s still possible that a recession won’t be necessary if supply constraints begin to ease, said Claudia Sahm, a former Fed economist. “If we don’t fix the delivery issues, we’ll have to see consumers slow down their spending,” she said. “Growth must slow down, business investment slow down. It just needs to get a little hotter.”
Ultimately, though, the Fed wants inflation to fall — and it’s up to Powell and his colleagues to decide how quickly they want that to happen.
“If they want 2 percent and they want it now, they can get it,” she said. “But to get it, we would need a recession.”