History suggests US won’t be able to prevent a recession
With inflation surging to a new 40-year high and continuing to accelerate, the Fed is expected to lift interest rates by a half-percentage point at the end of its next meeting on May 4, 2022. It will be the second of seven planned rate hikes in 2022 – following a quarter-point increase in March – as the Fed tries to cool consumer demand and slow rising prices.
By raising interest rates, the central bank is hoping to achieve a proverbial “soft landing” for the U.S. economy, in which it’s able to tame rapid inflation without causing unemployment to rise or triggering a recession. The Fed and professional forecasters project that inflation will recede to below 3% and unemployment will remain under 4% in 2023.
Our recent research, however, suggests that engineering a soft landing is highly improbable and that there is a significant likelihood of a recession in the not too distant future.
That’s because high inflation and low unemployment are both strong predictors of future recessions. In fact, since the 1950s, every time inflation has exceeded 4% and unemployment has been below 5%, the U.S. economy has gone into a recession within two years.
Today, inflation is at 8.5% and unemployment is at 3.6% – suggesting a recession will be very hard to avert.
To bring down surging inflation, the Fed will now try to raise interest rates to curb consumer demand.
The resulting increase in borrowing costs can help slow economic activity by discouraging consumers and businesses from making new investments. But it would come at the risk of causing major economic disruptions and pushing the economy into a recession. This is the soft landing: Interest rates rise and demand falls enough to lower inflation, but the economy keeps growing.
The history of engineering soft landings is not encouraging, however. We found that every time the Fed has hit the brakes hard enough to bring down inflation in a meaningful way, the economy has gone into recession.
While some have argued that there have been several examples of soft landings over the last 60 years, including in 1965, 1984 and 1994, we show in our analysis that these periods had little resemblance to the current moment.
In all three episodes, the Fed was operating in an economy with significantly higher unemployment, lower inflation and lower wage growth. In these historical examples, the Fed also raised interest rates well above the inflation rate – unlike today, where inflation is at 8.5% and interest rates are projected to remain below 3% through 2023 – and explicitly acted early to preempt inflation from spiraling, rather than waiting for inflation to already be excessive.
One reason the Fed’s challenge is particularly difficult today is that the labor market is unprecedentedly tight, meaning the demand for workers is far outpacing the available supply of them. A tight labor market implies that companies need to raise wages to attract new workers.
The U.S. economy today is facing additional inflationary pressures from higher grain and energy prices due to the Ukraine war and more supply-chain disruptions as COVID-19 forces new lockdowns in China. These factors threaten to exacerbate inflation even more over the coming year.
In our assessment, the inflation problem facing the Fed today is substantial and unlikely to be resolved without a significant economic slowdown. Overall, the combination of an overheating economy, surging wages, policy delay by the Fed and recent supply shocks means that a recession in the next couple of years is certainly more likely than not.
[Abridged]