Fed’s path between inflation and recession

Last week’s surprisingly bad news on inflation — prices rose 8.6% in the year to May, the highest for 40 years — and the financial markets’ anxious reaction have seriously complicated the Federal Reserve’s job. With policy makers set to announce their latest interest rate decision along with projections for the rest of this year, the Fed’s prospects for curbing inflation while avoiding recession are fast receding.
Having previously expected an increase of half a percentage point in the policy rate, many analysts are now predicting a rise of 75 basis points. The focus on the increase is misleading. What the Fed says about the outlook matters more than any extra quarter-point. Whether it’s 50 or 75 basis points this time, unexpectedly high inflation, should it persist, will call for a faster-than-advertised pace of tightening between now and the end of the year — even if this increases the risk of recession. That’s the message the Fed needs to send. After inflation subsided slightly in April, some analysts expressed hope the worst was over. They were mistaken. Prices continue to rise quite broadly, and in an extraordinarily tight labour market they’re dragging wages down with them. To be sure, supply-side shocks — first the pandemic, then the war in Ukraine and subsequent sanctions against Russia — are principal drivers. Some of the upward pressure on prices will therefore subside in due course. But it’s taking longer than expected, and new inflationary forces are becoming more apparent.
How bold should the Fed be? It ought to be guided not by a rigid commitment to a particular path of interest rates but by the need to press down on the growth of demand, bringing it back to a pace consistent with low inflation and continued growth in output. The recent fall in share prices and rise in market-determined interest rates — which the inflation news helped to accelerate — should be weighed in the calculation, alongside other signs of growing economic pessimism. In one way, the market’s gloom over the prospects for output and corporate earnings is welcome: It attests to the Fed’s credibility. If inflation stays high, investors are saying, the Fed can be counted on to act.
That’s helpful, because higher market-driven interest rates and correspondingly lower asset prices constitute a brake on demand regardless of the policy rate. The more convinced investors are that the Fed will do what’s necessary, the less brutal it will actually need to be.
The right answer when it comes to setting the policy rate is neither certain nor fixed; it depends on changing circumstances and simply can’t be predicted. If financial markets had shrugged off the new inflation number, the case for a full percentage point increase in the policy rate this week would have been strong. As things stand, a rise of 50 basis points, together with a higher path for projected rates over the coming months, should suffice — but the Fed must leave no doubt that, absent progress on inflation, it’s ready to step up the pace again.

—Bloomberg