The Federal Reserve appears to be inching closer to an outcome that its own economists considered unlikely just six months ago: reducing inflation to a normal range without plunging the economy into a recession.
Many things could still go wrong. But inflation has dropped significantly in recent months; at 3.1 percent annually, up from a high of 9.1 percent in 2022. At the same time, growth is strong, consumers are spending and employers continue to hire.
That combination has been a surprise to economists. Many had predicted that cooling a red-hot labor market with many more job openings than available workers it would be painful process. Instead, workers returned from the margins of the labor market to fill vacant positions, contributing to a relatively easy rebalancing. At the same time, the recovery of supply chains has helped increase inventories and alleviate shortages. Goods prices have stopped driving inflation up and have even begun to reduce it.
The Federal Reserve expects “a continuation of what we've seen, which is for the labor market to come into better equilibrium without a significant increase in unemployment, for inflation to decline without a significant increase in unemployment, and for growth to moderate without a significant increase of unemployment”. “Federal Reserve Chairman Jerome H. Powell said Wednesday.
As Fed officials look ahead to 2024, they are aiming squarely for a soft landing: Officials are trying to assess how long they need to keep interest rates high to ensure inflation is completely under control without slowing economic growth to a halt unnecessarily. painful That maneuver is likely to be delicate, which is why Powell has been careful to avoid declaring victory prematurely.
But the authorities see it clearly in sight, based on their economic projections. The Federal Reserve chair signaled Wednesday that rates were unlikely to rise from their 5.25 to 5.5 percent level unless inflation experiences a surprising resurgence, and central bankers predicted three rate cuts by late 2024 as inflation continues to cool and unemployment rises only slightly.
If they manage to make that landing, Powell and his colleagues will have accomplished an enormous feat in American central banking. Historically, Fed officials have steered the economy into a recession by trying to cool inflation from levels like those it reached in 2022. And after several years during which Powell has faced criticism because by not anticipating how long-lasting and serious inflation would be, such success would likely shape his legacy.
“The Federal Reserve is looking pretty good right now, in terms of how things are turning out,” said Michael Gapen, head of U.S. economics at Bank of America.
Respondents to a survey of market participants conducted periodically by research firm MacroPolicy Perspectives are more optimistic than ever about the chances of a soft landing: 74 percent said a recession was not necessary to bring inflation down to the target. the Federal Reserve in a December 1 survey. Poll 1-7, down from a low of 41 percent in September 2022.
People were pessimistic about the prospects for a soft landing, in part because they thought the Federal Reserve had been slow to react to rapid inflation. Powell and his colleagues argued throughout 2021 that higher prices were likely to be “transient”, even as some prominent macroeconomists warned that it could last.
The Federal Reserve was forced to dramatically change course when those warnings proved prescient: Inflation has now been above 2 percent for 33 consecutive months.
Once central bankers began raising interest rates in response, they did so quickly, pushing them from near zero in early 2022 to their current range of 5.25 to 5.5 percent in July of this year. Many economists worried that stopping the economy so abruptly would cause whiplash in the form of a recession.
But the so-called transitional seems a little better now: “transitional” simply took a long time to come together.
Much of the reason inflation has moderated is due to the recovery of supply chains, reducing shortages of key goods like cars, and a return to something that more closely resembles pre-pandemic spending trends. in which households purchase a variety of goods and services rather than simply stay-at-home splurges such as sofas and exercise equipment.
In short, the pandemic problems that the Fed hoped would be temporary have faded. It just took years instead of months.
“As a founding member of the transitional team, it took a lot longer than many of us thought,” said Richard Clarida, a former vice chairman of the Federal Reserve who served until early 2022. But, he noted, things have adjusted.
The Federal Reserve's policies have played a role in cooling demand and preventing consumers from adjusting their expectations about future inflation, so “the Fed deserves some credit” for that slowdown.
While higher interest rates haven't healed supply chains or convinced consumers to stop buying so many sweatpants, they have helped cool the market somewhat for key purchases like homes and cars. Without those higher borrowing costs, the economy could have grown even more strongly, giving companies the means to increase prices more dramatically.
Now, the question is whether inflation will continue to cool even as the economy moves at a solid pace, or whether a sharper economic slowdown will be necessary to reduce it completely. The Federal Reserve itself expects growth to slow substantially next year, to 1.4 percent from 2.6 percent this year, based on new projections.
“They've certainly done very well, and better than I had anticipated,” said William English, a former senior economist at the Federal Reserve who is now a professor at Yale. “The question remains: Will inflation return to 2 percent without more slack in the labor and goods markets than we have seen so far?”
To date, the labor market has shown few signs of breaking down. Hiring and wage growth have slowed, but unemployment remained at a historically low level of 3.7 percent in November. Consumers continue to spend and growth in the third quarter was unexpectedly strong.
While these are positive developments, they keep alive the possibility that the economy is too buoyant for inflation to cool completely, especially in key service categories.
“We don't know how long it will take to go the last mile with inflation,” said Karen Dynan, a former Treasury chief economist who teaches at Harvard.
With this in mind, setting policy next year could prove to be more art than science: if growth is cooling and inflation is falling, cutting rates will be a fairly obvious choice. But what happens if growth is strong? What happens if inflation progress stagnates but growth collapses?
Powell acknowledged some of that uncertainty this week.
“Inflation continues to fall, the labor market continues to regain balance,” he said. “So far everything is going well, although we assume that it will be more difficult from now on, but so far it has not been like that.”
Powell, a lawyer by training who spent much of his career in private equity, is not an economist and has at times expressed caution about using key economic models and guides too religiously. That lack of devotion to models may come in handy over the next year, Bank of America's Gapen said.
It may make the head of the Federal Reserve (and the institution he leads) more flexible as they react to an economy that has been devilishly difficult to predict because, in the wake of the pandemic, past experience is proving to be a bad precedent. .
“Maybe it was right that a guy who was skeptical about the frameworks ran the ship during the Covid period,” Gapen said.
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