“Unless we have a set of very surprising and positive developments,” Summers told POLITICO, “we’re not likely to see the inflation rate come all the way down to [the Fed’s] target without there being some level of meaningful economic distress.” Summers, who was also a top adviser in the Obama White House, has derided earlier Fed forecasts as “delusional.”
The outcome has far-reaching implications for the country, including for countless American families who have benefited from an extraordinarily strong labor market but also grappled with historic price surges that have eaten up pay raises and strained household budgets. It also presents an enormous challenge for Joe Biden’s presidency, since a miscalculation by the Fed could result in a nosediving economy, persistently high inflation, or worse, both.
While the Fed in June saw the unemployment rate hitting 4.1 percent by the end of 2024, some economists say it may need to rise to nearly 6 percent, and stay there for some time, to bring inflation down — an increase that would undoubtedly coincide with a recession.
Diane Swonk, chief economist at KPMG, said it’s not a question anymore of whether the Fed can avoid a recession, but whether it will accept a mild downturn that slowly grinds down inflation, or a bigger one that does the job quickly.
“The Fed’s optimal scenario is that we get there with only a modest increase in unemployment,” Swonk said. “I think within the Fed, there’s some acknowledgment that it may have to be more than that.”
The Labor Department reported on Friday that employers added 528,000 jobs in July, far above economists’ forecasts. The unemployment rate fell to 3.5 percent.
Still, broader economic activity has clearly slowed. The government last week said gross domestic product fell in the second quarter, following a decline in the first three months of the year, raising worries about an imminent recession.
Meanwhile, Powell is under pressure from some left-leaning economists and politicians, such as Sen. Elizabeth Warren (D-Mass.), who argue that the Fed’s campaign to jack up interest rates will do little to quell inflation that’s largely driven by supply shocks like the war in Ukraine and Covid lockdowns in China. In a Wall Street Journal op-ed last week, Warren also blasted Summers as a “cheerleader” for higher rates and “someone who has never worried about where his next paycheck will come from.”
Other skeptics say it’s on the Biden administration and Congress to do more to help the Fed bring prices under control and avoid derailing the economy.
“A recession will not help us tackle inflation — a recession will only hurt working families,” said Sen. Sherrod Brown (D-Ohio), chair of the Senate Banking Committee. “We need to bring down prices for workers and families, and tackle inflation at its source — that means fighting corporate price gouging and consolidation, expanding our housing supply and investing in our supply chains.”
Democrats are poised to advance legislation soon, negotiated by Senate Majority Leader Chuck Schumer and Sen. Joe Manchin (D-W.Va.), that they say would help ease price pressures by reducing federal budget deficits — though some forecasters estimate the effect on inflation would be small and wouldn’t materialize right away.
Powell says the Fed doesn’t have the luxury of ignoring supply constraints and hoping inflation comes down on its own. And he stressed that policymakers won’t balk at slower growth or a softening labor market as they continue to raise rates.
“Those are things that we expect, and we think that they’re probably necessary … to be able to get inflation back down on the path to 2 percent and ultimately get there,” he said at a press conference last month.
How much pain will it take?
Summers likened the process to an addict going through detox — it’s going to involve some withdrawal symptoms. For now, the Fed still expects those symptoms to be mild, though Powell acknowledges the path to avoiding recession has narrowed.
In June, Fed officials projected that inflation would fall from an estimated 5.2 percent at the end of this year to just above their 2 percent goal by the end of 2024. At the same time, they expected the jobless rate would rise only half a percentage point, to 4.1 percent from 3.6 percent in June.
Part of their optimism reflects a view among officials that a decline in job vacancies could take some heat out of the labor market and help ease price pressures without driving up unemployment much.
As the economy slows, employers typically pull back on hiring and start laying people off. But with so many vacancies relative to the supply of available workers, Fed officials expect that a decline in job openings won’t necessarily correspond to as big of a rise in the jobless rate this time.
Not everyone is convinced.
In a paper last month, former International Monetary Fund chief economist Olivier Blanchard, Harvard research fellow Alex Domash and Summers said the Fed’s hope “flies in the face of theoretical and empirical evidence.” Looking back at labor market data since the 1950s, there has never been an example where the job vacancy rate came down in a substantial way without a significant increase in unemployment, they wrote.
“Fighting inflation will require a decrease in vacancies and an increase in unemployment,” they wrote. “There is no magic tool.”
In addition, the so-called natural rate of unemployment — the rate at which economists believe joblessness starts to fuel higher inflation — is much higher than it was before the pandemic, they argued. That means the labor market is even tighter than many assume, and the unemployment rate will need to rise much more than the Fed expects to bring inflation down, they wrote.
Fed economist Andrew Figura and Governor Chris Waller pushed back in a blog post Friday, saying a soft landing is still possible. They recognized “it would be unprecedented for vacancies to decline by a large amount without the economy falling into recession,” but said this is an unprecedented situation.
The problem is the Fed doesn’t have precise tools to target a particular vacancy rate or unemployment rate to slow the economy just enough to bring inflation down. And it doesn’t have a “recession” button it can push even if it wanted to.
That raises the risks that the central bank will raise rates too high, causing a painful contraction and potentially bringing inflation down too much, said economist Wendy Edelberg, director of the Hamilton Project at the Brookings Institution.
The bigger worry, she added, is that the economy slows and inflation remains high. That could happen if inflation expectations begin to rise, or if supply shocks continue to batter the economy.
It’s still possible that a recession won’t be necessary if supply constraints start to ease, said Claudia Sahm, a former Fed economist. “If we don’t resolve supply issues, then we do need to see consumers slow down their spending,” she said. “Growth has to slow down, business investment slows down. Things just have to get a little less hot.”
But ultimately, what the Fed wants to see is inflation coming down — and it’s up to Powell and his colleagues to decide how quickly they want to see that happen.
“If they want 2 percent and they want it now, they can get it,” she said. “But then to get it, we would need a recession.”