After initially dismissing the threat of persistent inflation, the Federal Reserve is now fully committed to bringing it under control with a series of interest-rate hikes. But some worry that the central bank is overcompensating for its mistakes by doing unnecessary damage to the broader economy. I spoke with Ryan Sweet, a senior director of economic research at Moody’s Analytics, about whether Jerome Powell is making the right move, the risk of stagflation, and what a U.S. recession would look like compared to previous ones.
A few weeks ago, it seemed there was some optimism that the U.S. might escape the current era of high inflation without the sting of high unemployment and a full-scale traditional recession. Since then, the market has plummeted and the overall outlook appears gloomier. Why?
I think the trigger, at least initially, was the Core Consumer Price Index, which came in a little bit hotter than what people were anticipating. Some of the stickier components of inflation are picking up. Shelter, for example — shelter inflation hasn’t peaked yet, so that’s going to be a persistent issue. We needed a lot of goods disinflation, particularly in new and used vehicles, to offset some of the services inflation, and we didn’t get that.
And financial-market conditions have tightened noticeably since the Fed’s September meeting. Reading between the lines, the Fed is laser-focused on taming inflation, and they’ll stomach a recession to do it. And that’s essentially what they’re forecasting: They’re predicting a rise in the unemployment rate, which normally only occurs in a recession. They’re going to break inflation or they’re going to break the economy. And I think the risks are rising that we don’t have a “soft landing,” where inflation goes back down to the target rate and we skirt a recession.
For a long time last year and early this year, the Fed took a laissez-faire approach to inflation, thinking, as many analysts did, that it would be fairly transitory. Obviously that was incorrect, and Fed Chair Jerome Powell admitted his mistake. To what extent do you think his laser focus now is the correct course, based on what’s happening in the economy, and to what extent is it driven more by a need to not get this wrong a second time? Is it possible that the Fed is actually overreacting here?
I think the risk is that they are overreacting. What they want to do is have GDP growth well below potential, bring down job growth, and take some pressure off wages, which by extension cools inflation. But that’s for demand-side inflation. And most of our inflation problems are on the supply side. It’s higher energy prices because of Russia’s invasion of Ukraine; it’s supply-chain stress, which has driven up prices of new and used vehicles and children’s apparel, for example. Not all our inflation issues can be solved by the Fed raising interest rates. Rising interest rates will cool the demand side of the economy. We’re already seeing evidence that the interest-rate-sensitive parts of the economy, including housing, are weakening.
But unless the Fed starts going out and drilling wells or driving container ships, they’re not going to be able to affect the supply side, where we’re seeing a lot of inflation. And it seems like they kind of panicked when they raised rates by 75 basis points just when it looked like inflation may have peaked. If you look at global shipping rates, they’re coming down, and oil prices have come down. This is going to help over time — it’s not going to be next month or in the next two months, but going forward we’re going to see less inflationary pressures.
But haven’t we been hearing that same line — that we’re about to start seeing less inflationary pressure — for a year now?
I think economists were starting to sound like Chicago Cubs fans before they won The World Series: “Just wait till next year.” But there are reasons economists are making these forecasts. Global shipping rates for container traffic prices were continuing to rise, but now they’ve clearly rolled over. Now you can see it in oil, you see it in lumber, you’re seeing it in copper — it’s broad-based.
To what extent can the Biden administration cool the supply-side pressures you mentioned?
I think some of the steps they’ve taken, like releasing some oil from the strategic petroleum reserve, have helped a little bit on the margin. Their climate policies push against them opening up or adding more leases for natural-gas and oil production. The Biden administration has got to be careful because how we get into a stagflation scenario — where you have high inflation and high unemployment — is with policy mistakes. And you can go back and look at the late 1970s and early 1980s, when we had policy errors on both the monetary policy front and the fiscal policy front. For example, any chatter of price controls should be shot down immediately — they don’t work. But the odds of stagflation in the U.S. are pretty low, 10 or 15 percent.
Not that low! That seems uncomfortably high.
For perspective, in any year the odds of a recession are usually around 10 to 15 percent. So the stagflation risk isn’t zero, but it’s not 50-50, which is more likely the odds in, say, Europe or the U.K.
It doesn’t seem like any country is doing terrifically in this regard. Europe is in the midst of a deep energy crisis, and Germany and the U.K., which just instituted an oddly timed tax cut, look headed toward recession. China’s COVID Zero policy is a mess for the economy. The U.S. has been a relative bright spot so far. The expression goes that when America sneezes, the world catches a cold. But now it seems like the opposite might be happening.
I’ve always heard that expression — “the cleanest shirt in the dirty laundry.” Our economy is holding up reasonably well, particularly when compared to some of the other developed economies in the world. This could be potentially the first recession — and our baseline forecast is not for recession in the U.S., but it’s going to be close because the odds are uncomfortably high — but this could be the first recession in recent memory that the U.S. didn’t pull the rest of the world in. It’s vice versa. The world could pull us into a recession, because we’re not going to be able to skirt the side effects of Germany falling into a recession, or the U.K., or the broader Euro zone. And when the economy is vulnerable like we are today, anything else that goes wrong could be the difference between flirting with a recession and falling into one.
How would that work? Let’s say Germany does tip into recession. How would those side effects hurt the U.S.?
One would be through trade. Demand for our exports would decline, and that would negatively affect manufacturing in the U.S. Right now, if you look at the economy, housing is struggling, and the worst is not anywhere close behind us — it is going to continue to weaken. Throw manufacturing on top of it, and now the dominoes start to fall. But again, as the consumer goes, so goes too the U.S. economy. They’re crucial if we’re going to hang in there. This goes back to the labor market and as long as job growth is solid, the unemployment rate doesn’t rise too much, we could be okay. But the concern is that if more and more countries fall into a recession, manufacturing starts laying off workers, and layoffs in construction start to increase. And that could start to really take a toll on the labor market. And then once unemployment goes up, there’s a psychological effect where if you see your friends, family, neighbors getting laid off, then you run for the bunker, you pull back on spending because you’re worried about your own job security. And that’s how this negative reinforcement cycle starts to kick in.
For the most part, I watch what consumers and businesses do, not what they say. They can say, “Oh, I’m really down in the dumps.” And you can see that in different measures of consumer confidence right now. But they’re out there still spending, because we have a low unemployment rate. Nominal wage growth is pretty strong from what we saw pre-pandemic — there’s two and a half trillion dollars in excess savings. So consumers are still spending, even though their confidence would suggest otherwise.
I interviewed Larry Summers a while ago, and he predicted that there was no way of getting out of the situation without hitting 6 percent unemployment. What sectors of the economy would be hardest hit in terms of layoffs in that scenario?
With a 6 percent unemployment rate, I would assume that the Feds got interest rates higher than we are assuming in the baseline. You’d have layoffs in housing, you’d have layoffs in manufacturing. The consumer sector would be hit hard as well, because when unemployment goes up, people cut back on spending. They’re not going to go out to restaurants and bars or spend time on leisure travel.
Given that inflation is coming down in your view, would a downturn be on the milder side? Because the Fed might see that unemployment is rising and inflation is falling, and they could pump the brakes on this policy sooner rather than later.
If we do have a recession — and hopefully we don’t and the Fed is able to pull this rabbit out of their hat — it would be a mild one. Because what typically determines the severity and the duration of a recession is the catalyst. So what’s the reason we fall into a recession? The pandemic, for example, or a financial crisis, or a housing bubble. Those led to long or deep recessions in the pandemic’s case.
But there’s no glaring imbalance in the economy today. Household balance sheets are in really good shape. Nonfinancial corporate balances are not in as good shape as households, but they’re still pretty solid. State and local governments are flush with cash. The only balance sheet in the economy that has a problem is the federal government, and that’s not an issue for a recession or a deep downturn. So if we do have a recession, it should be mild, because the Fed will say, “All right, we overdid it, we can back off and start cutting interest rates” and that should help limit the severity and the duration of it.
This interview has been edited for length and clarity.
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