If the U.S. economy slips into a recession in the second half of the year, as most forecasters expect, the Federal Reserve says it will be doling out some tough love instead of a lifeline.
There’s a good chance the Fed has paused its aggressive interest rate hikes but repeatedly has signaled it probably won’t cut rates this year, even in a mild recession, because it wants to subdue a historic inflation surge.
Financial markets, and some economists, have a terse response: Nonsense.
Markets predict the Fed will lower interest rates by November and give 30% odds that it will make a move in September.
“They’re not going to stick to their guns,” says Joe LaVorgna, chief U.S. economist for SMBC Group and a former top economic advisor in the Trump administration. “There’s no way they’re going to be able to sit and watch (employment) come down” as job losses mount.
LaVorgna points to prior recessions, noting the Fed typically reverses course from fighting inflation to trying to head off or minimize a downturn quickly as the economy weakens, seemingly contradicting itself. Since the 1950s, the median lag between the last rate hike and the first cut is just two months, LaVorgna says.
Rate cuts would juice the stock market and economy but risk another inflation spike.
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How much did the Fed recently raise interest rates?
The Fed raised its key rate by a quarter percentage point early this month, capping 5 points of increases in 14 months, its most aggressive such campaign in four decades. According to Fed policymakers’ forecasts, it won’t start cutting until late January at the earliest, even in the event of the mild recession that Fed staffers are projecting this year. That’s a nine-month lag. Such a hard-nosed stance in the face of widespread layoffs would be highly unusual.
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How does raising interest rates help the economy?
Jonathan Millar, a former top economist at the Fed, says this time is different because annual inflation has remained stubbornly high, falling from a 40-year high of 9.1% last June to 4.9% in April, still well above the Fed’s 2% target. Fed Chair Jerome Powell has said it’s more critical to stamp out inflation so it doesn’t become entrenched in the nation’s psyche, as it did the 1970s, than to stave off a modest downturn, which can be remedied by lowering rates.
Higher interest rates make it more expensive for consumers and businesses to borrow, dampening spending and prodding companies to hold prices steady or lift them just slightly. But the Fed’s flurry of rate increases is also expected to be the chief cause of any recession.
To a large extent, the Fed’s strategy is rooted not just its actions but its promises to raise rates or keep them elevated because that rhetoric can affect consumers’ inflation expectations. If workers believe prices will continue to climb, they’re more likely to demand pay raises, a cost that businesses may offset by nudging prices still higher.
“We on the committee have a view that inflation is going to come down—not so quickly, but it’ll take some time,” Powell said at a news conference this month. “And in that world, if that forecast is broadly right, it would not be appropriate…to cut rates, and we won’t cut rates.”
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Will the Fed reduce interest rates soon?
Powell suggested that if inflation falls more rapidly, as some economists expect, the Fed could trim rates. It’s also possible the collapse of Silicon Valley Bank and two other banks will continue to threaten regional banks if many customers withdraw deposits, accelerating a pullback in lending. That could trigger a deeper downturn and bring down inflation more swiftly – either of which could lead the Fed to lower rates within months, economists say.
“Chair Powell right now does not want to talk about (reducing rates),” Ian Shepherdson, chief economist of Pantheon Macroeconomics, wrote in a note to clients. “But that will change; the Fed will do what the data tell them to do, and the data are heading south.”
LaVorgna believes the Fed will cut rates this year in part because a recession will be more severe than the Fed expects. But he says the Fed will shift gears even if there’s a mild to moderate downturn, as it predicts, with unemployment rising from the current 3.4% to 4.5%.
“The Fed typically isn’t good at knowing when it’s going to have a policy pivot,” LaVorgna says.
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How did the Fed respond to the Great Recession?
In August 2007, the housing crisis that led to the start of the Great Recession later that year was already brewing. Many low- and middle-income homeowners were defaulting on subprime mortgages and banks had started restricting lending.
Then-Fed Chair Ben Bernanke noted the financial strains but added, “I think the odds are that the market will stabilize,” according to a transcript of a closed-door Fed meeting.
Meanwhile, he said he continued to “see risks” from inflation. While inflation had fallen to 2.4% in July from 4.1% a year earlier, Bernanke agreed with colleagues who thought that the improvement could be temporary and that low unemployment (4.6%) could push wages and prices higher.
“I agree with those who still view the risk to inflation as being tilted to the upside,” Bernanke said.
In its post-meeting statement, the Fed held rates steady, saying “a sustained moderation in inflation pressures has yet to be convincingly demonstrated.”
Just three days later, the Fed cut its discount rate, citing “dislocations to money and credit markets,” LaVorgna noted. And at its September meeting, the central bank lowered its benchmark federal funds rate by a half percentage point, following it with quarter point cuts in October and December.
“I am concerned about getting ahead of what could be an adverse dynamic between the job market and the housing market,” Bernanke said at the September meeting. “On inflation, I think the slowing that we are likely to see will probably remove some of the upside risk that we have been concerned about.”
LaVorgna said the Fed’s current stance is “eerily similar,” pointing to the current regional bank troubles.
Millar, however, says the Fed’s dilemma in 2007 was different. The 2007-09 financial crisis was far more damaging because it affected the nation’s largest banks, which were tightly interconnected and dramatically reined in lending. Regional banks don’t have as much impact on the broader economy, though an intensifying crisis that spreads to more regional banks could more severely hurt lending and growth, Millar says.
Also, he notes, inflation, at 4.9%, is twice as high now as it was in 2007, making the Fed’s decision to cut easier back then.
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What happened in the 1990-91 and 2001 recessions?
Inflation was also elevated in July 1990 and January 2001, at 4.8% and 3.7%, respectively, and the Fed had been holding rates unchanged at historically high levels. But as the economy began to wobble amid the high rates – along with an oil spike in 1990 and the dotcom crash in 2001 – the Fed swiftly shifted course and started cutting.
On November 15, 2000, the Fed noted that high energy prices could increase inflation expectations even while household and business demand was ebbing. It held rates steady, adding that “the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures…”
By January 3, the Fed had changed its tune, slashing its key rate by a half percentage point ahead of 20,000 job losses that month. It pointed to “further weakening of sales and production…and high energy prices sapping household and business purchasing power. Moreover, inflation pressures remain contained.”
Says Millar, “Inflation wasn’t nearly as big an issue then as it is now. So it was an easier choice for them to make.”
Even so, LaVorgna believes a weakening labor market with tens of thousands of monthly job losses could prompt a Fed turnabout.
“When the economy turns down, they’re going to be under tremendous pressure to do something about it,” he says.
