According to the Federal Reserve, reducing inflation without significantly increasing unemployment is possible, but many factors are out of its control.
With calibrated interest-rate increases intended to take the steam out of an already-overheated economy, the possibility of slowing soaring demand is possible, but the Fed is “strikingly behind.”
So, what will it take to successfully fix the perfect storm of a hot economy combined with rising inflation?
U.S. Treasury Secretary Janet Yellen, a former Fed chairperson herself, sees the continuing risk of failure. “It will require skill and also good luck,” said Yellen.
Over the past 80 years, the Federal Reserve has never had to lower inflation as much as it is trying to do now without causing a recession. To lower inflation by four percentage points, the Fed will need many out-of-control factors to fall into place and break its way to be successful.
Optimism mixed with caution
Federal Reserve officials can find a reason for caution and optimism by taking a close look at history.
Over the past 80 years, during seven different episodes, inflation has fallen as much as the Fed wants to drop it now, but with varying outcomes.
With history as the best indicator of future success, it is theoretically possible to achieve the desired result, the risk of failure is high. The Fed’s situation is made more difficult because the bank is trying to lower inflation that is already soaring.
In the current situation, the labor market will be the key. During a typical recession, joblessness rises dramatically.
The current U.S. unemployment rate is particularly low, at 3.6%, while demand from workers remains high as millions of unfilled job openings remain for companies in need of workers.
Fed officials believe they can curb the demand for workers, which would cause employers to rid themselves of job vacancies without laying off already-existing workers, all while tamping down inflation.
This is what is referred to as a “soft landing.”
A hard landing
Fed Chairman Jerome Powell recently explained, “No one expects that bringing about a soft landing will be straightforward in the current context — very little is straightforward in the current context.” He also added that the central bank faces a “challenging task.”
In the 1980s, the United States experienced a “hard landing” — falling into deep, double-digit unemployment after the Fed pushed its key benchmark interest rate to almost 20% to tame stubborn, sky-high inflation that had been rising for well over a decade.
A bumpy landing
Short-lived recessions and inflation spikes characterized less severe but still bumpy landings during the 1950s.
During that time, the unemployment rate didn’t reach dramatic highs even when the economy’s output contracted.
In the 1970s, the U.S. experienced aborted landings when inflation dipped and then lurched higher due to policy missteps and OPEC oil embargoes.
Missteps included the Fed’s hesitation to raise interest rates aggressively.
A soft landing
America has experienced soft landings as well. As recently as 1994, Federal Reserve Chairman Alan Greenspan raised interest rates sharply, by 6%, in February 1995, up from 3% a year prior.
With the move, the unemployment rate continued to drop. Unlike in 1994, the Fed is currently trying to lower inflation that is already soaring rather than preventing it from rising, which Greenspan did.
While the Fed has indicated that while they are aiming for a soft landing, they will keep increasing interest rates as much as required to lower inflation, even if the result is a downturn.
The hope of the Federal Reserve
Even before Russia invaded Ukraine, Powell laid the groundwork for aggressive rate increases.
The driving factor is concern over an overheating labor market. Covid-19 lockdowns in China combined with the war have raised prices and further disrupted supply chains, making the task increasingly harder for the Fed.
Consumer prices rose to 6.4% in February compared to the previous February. Core prices, which don’t include more volatile energy and food price swings, climbed 5.4%, the highest in four decades.
Fixing imbalances in the economy
The success of the Fed depends on several factors outside its realm of control. The factors include reducing energy prices; whether global energy supplies recover from the shock of Russia’s invasion of Ukraine; clearing supply logjams created by Chinese Covid-19 lockdowns; whether U.S. workers rejoin the labor force; whether Covid remains in check in the U.S.; easing wage pressures and the labor shortages and ending other economic disruptions related to Covid-19 including business closures.
If these factors and supply constraints ease, the Fed’s job will be easier. If not, the central bank will need to push rates higher to put the squeeze on demand. However, the move comes with a risk of more damage to the economy.
The success of the Fed hangs on the condition of the job market. U.S. companies listed 11.3 million unfilled jobs, four million more than before the coronavirus pandemic, which was already a level not seen before.