When Chairman Jerome Powell and other Federal Reserve officials meet this week to make their final decision on interest rates, they will do so on the cusp of achieving the elusive “soft landing” — the feat of curbing inflation without triggering a deep recession.
After the Fed began aggressively raising borrowing costs early last year, most economists predicted it would send the economy into a tailspin as consumers cut spending and businesses cut jobs and expansion plans.
However, even though the Federal Reserve is preparing to raise its key interest rate on Wednesday for the 11th time since March 2022, to its highest point in 22 years, no one is panicking. Economists and financial traders are becoming more optimistic about the possibility of achieving what some call “clean inflation” – a steady relief of inflationary pressures without deflation. Most economists believe that raising the Fed’s benchmark interest rate, to around 5.3%, will be the last, although they warn that this rate, which affects many consumer and business loans, is likely to remain at its peak through 2024.
“I wasn’t very optimistic about a soft landing a few months ago,” said Jeremy Stein, a Harvard University economist who served on the Fed’s board of governors from 2012 through 2014.
Goldman Sachs economists, who have painted a more optimistic view than others, cut the probability of a recession to just 20%, from 35% earlier this year.
Even economists at Deutsche Bank, among the first large banks to predict a recession, are encouraged by the direction of the economy, although they still expect a downturn later this year.
“We have more flexibility within the economy than I would have expected at this point in time, given the extent of the rate increases we’ve had,” said Matthew Luzzetti, chief US economist at Deutsche Bank.
Lozzetti points to permanent consumer spending as a major driver of economic growth. Many Americans still have additional savings resulting from the pandemic, when the government distributed many stimulus checks and people saved by spending less on travel, restaurant meals, and entertainment.
Employment remained healthy, with employers adding 209,000 jobs in June and the unemployment rate falling to 3.6%. That’s close to the lowest rate in half a century and where it was when the Federal Reserve started raising interest rates 16 months ago – a sign of economic resilience that almost no one expected.
At the same time, inflation has fallen steadily. In June, prices rose just 3% from a year earlier, down from a peak of 9.1% in June 2022 although still above the Fed’s 2% target.
What is encouraging is that measures of core inflation have fallen. “Core” prices, which exclude volatile food and energy costs, rose just 0.2% from May to June, the slowest monthly rise in nearly two years. Compared to a year ago, core inflation was still relatively high at 4.8%, although it fell sharply from 5.3% in May.
Some economists warn that a recession cannot be ruled out just yet. They point out that the Fed’s interest rate increases have made the cost of buying a home, financing a car, or expanding a business more onerous.
And with inflation still not fully contained, Fed officials still have to make all the clear. A day after the government reported unexpectedly mild inflation, Christopher Waller, a key member of the Federal Reserve, said he needed to see more evidence of smaller price increases before he could be sure inflation would slow. Even then, Waller said, two more quarter-point rate hikes are likely to be “necessary to keep inflation moving toward our target.”
Waller worried that the Fed might be “faking” a temporary slowdown in inflation, only for prices to pick up again, which they previously did in mid-2021 and fall 2020.
Similarly, Lori Logan, President of the Federal Reserve Bank of Dallas, said she favored a rate hike at last month’s meeting, when the Fed kept interest rates unchanged after 10 consecutive increases. Speaking ahead of the latest inflation report, Logan indicated that more increases are needed.
Some economists warn that bringing inflation down from above 9% to 3% was the relatively easy part. Getting it down to 2% will be more difficult and take longer. Average earnings have not kept pace with the price increases over the past two years, and workers may continue to press for steep wage increases. Higher wages will boost Americans’ spending power and may perpetuate inflation.
However, many other experts say they believe the recent moderate inflation readings could hold. Rental cost increases, which have already fallen, should fall further as more apartment buildings are completed.
Although Fed policymakers collectively predicted in June that they would raise the benchmark interest rate twice more this year, many economists believe that after this week’s hike, officials will hold rates steady when they meet next September. After that, inflation may be close enough to the Fed’s target that it will give up any further hikes.
In a question-and-answer session last week, Waller ruled out the possibility of skipping a rate hike again if inflation is as low in the next two months as it was in the latest government report.
Although used car prices are still much higher than they were before the pandemic, they fell in June and are expected to fall further. Furniture, appliances and clothing costs are also slowing. While restaurant prices are still high, they are rising more slowly.
“The breadth of the inflationary downturn is starting to widen,” said Umair Sharif, chief economist at Inflation Insights. “This is the kind of thing you’ve been hoping to see for a while.”
Sung Won Sohn, a professor of economics at Loyola Marymount University, said he remains worried the Fed will have to clamp down on the economy to slow inflation to 2% and eventually cause a recession and higher unemployment.
“The 2% inflation target… is an unrealistic target that can only be reached at huge cost,” Sun said. “There is a growing risk that the Fed will overreact, as they have in the past, and push the economy into a real, all-out recession, which is not necessary.”
Other economists have also expressed their concerns. A potential attack on UPS could slow shipments of goods, revive shortages, and raise prices. Workers in other industries, such as airlines and automakers, are also pushing for higher wages, which can lead to higher wage pressures.
It is known that achieving a soft landing, after inflation has risen significantly, is very difficult. But the economy has broken new ground several times since the pandemic.
“We are in uncharted territory.” said Riccardo Trezzi, founder of Underlying Inflation, a consulting firm, and former economist at the Federal Reserve and European Central Bank. “We should be able to say, ‘We don’t know.'”