Hard landing or harder? The Fed may have to choose

The writer is a former central banker and professor of finance at the University of Chicago Booth School of Business

Before Congress earlier this week, Federal Reserve Chairman Jay Powell said that “the final level of interest rates is likely to be higher than previously expected” and that “to restore price stability, we will likely need to maintain a restrictive stance for some time.” That was the dovish Fed on display, and markets crashed accordingly. Yet a few weeks earlier, Powell sent financial markets into a tailspin when he said: “We can now say for the first time that the disinflation process has begun.” Financial markets, accustomed to years of easy money, celebrate at the slightest sign that the Fed will ease its policy, making its task more difficult. But they’re not the only market that isn’t cooperating right now.

Labor markets have tightened, if anything, even though the Fed has raised interest rates by 450 basis points since March of last year, and Friday’s strong jobs report did little to ease concerns. While the production of goods is slowing down after the pandemic significantly increased consumption, more labor-intensive services are now picking up strongly. It is difficult to find workers, especially when it comes to hospitality and leisure. One reason for this is that the workforce is 3.5 million workers short of pre-Covid projections. Older workers understandably quit during the pandemic, and many did not return. Retirement continued to accelerate. And tragically, as Powell pointed out, Covid-19 has also killed half a million workers in the US, while slower immigration has led to about a million fewer workers than expected.

Additionally, given the difficult nature of leisure and hospitality jobs, workers sought opportunities elsewhere in the economy. And perhaps more importantly, companies held on to their employees precisely because hiring was so difficult. As long as they are not confident that the economy will slow down and they will not need these workers, and perhaps until they see enough unemployed people around them to indicate that labor accumulation will not be difficult in the future.

Other markets are also treading water. For example, US home sales have slowed significantly, but property prices have generally held up, likely because there is little supply on the market. Because mortgage rates have risen so much in the past year, a homeowner with a 30-year, 4 percent mortgage will have to pay much more in monthly payments if they move to a slightly better home with a new 7 percent mortgage. cent. Since you can’t afford to buy, you don’t sell. And since this limits housing supply on the market, there is only modest downward pressure on prices.

Finally, inflation is trending lower as supply chain disruptions from the pandemic and war-induced commodity disruptions are now being sorted out.

Belief in painless “spotless disinflation” and a soft landing leads to a self-reinforcing equilibrium in which few believe the Fed needs to do much more. As a result, workers are not being laid off, financial asset prices and housing are holding up, and households have jobs and assets to continue spending. But without some slack in the labor market, the Fed can’t feel comfortable pausing its efforts.

To get the job done, therefore, the Fed must force markets to abandon the belief that disinflation will result in only mild job losses. Indeed, a recent study by Stephen Cecchetti and others suggests that every disinflation since the 1950s has been accompanied by a significant increase in unemployment.

There are dangers if the Fed takes a soft landing of mild job losses out of the possible consequences. The first that Powell heard during his congressional testimony is that politicians will be furious if the Fed torpedoes the recovery they just bought with trillions of dollars in budget spending. The central bank is not immune to congressional ire.

Second, a benign balance can turn into a diabolical state. Markets may be having their Wile E. Coyote moment. Layoffs can encourage more layoffs now that businesses are confident they can hire back if needed. Laid-off workers, in turn, may be forced to sell their homes, depressing property prices and reducing household wealth. Unemployment and lower wealth can weigh on household spending, which in turn depresses corporate profits. This leads to more layoffs, declining financial markets and stress in the financial sector, and even more restrained spending. . . We may end up in a deeper recession than currently expected because it is difficult to get even a little unemployment.

Of course, the Fed could stimulate the economy by cutting interest rates, but it should be cautious about doing so until it sees enough slack building up in the labor market. If it turns too quickly, the markets will celebrate and the job will remain unfinished. But if you wait until there’s enough slack, layoffs can take on a momentum of their own.

The temptation then is for the Fed to be more ambiguous, keep a soft landing on the menu and pray for spotless inflation. If so, the Cecchetti study warns that the eventual unemployment needed to curb inflation could be much higher. The Fed’s only realistic option may be a hard landing and a harder landing. It might be time to make a choice.