Unlike many of his predecessors as head of the Federal Reserve, including Alan Greenspan, Ben Bernanke, and Janet Yellen, Jerome Powell isn’t a professional economist; he trained as a lawyer. Despite, or perhaps because of, this background, Powell has a knack for explaining the Fed’s actions in terms that non-economists can understand, and he demonstrated this ability again on Wednesday, during a much anticipated appearance in Washington, at the Brookings Institution.
The news Powell imparted is that the Fed is likely to slow down the pace of interest-rate hikes at its next scheduled meeting, two weeks from now. The central bank has raised the federal funds rate (a benchmark short-term interest rate) by 0.75 percentage points four times since June—three percentage points in total—in an effort to bring down inflation, and Powell signalled that an increase of 0.5 percentage point is likely this time. After his remarks, the Dow jumped more than seven hundred points, and closed the day up more than two per cent. Since the end of September, it has risen close to twenty per cent, a major move to the upside.
After his prepared remarks, Powell answered questions from David Wessel, a former Wall Street Journal columnist who is a senior fellow at Brookings, and from members of the audience. He took the opportunity to talk about how the Fed is trying to navigate a middle ground between crashing the economy with an overzealous effort to bring down inflation and allowing inflation to indefinitely remain far above the Fed’s target rate of two per cent. Throughout the discussion, he stressed the many factors that make the outlook so uncertain, from the lingering effects of the coronavirus pandemic here in the United States, to the war in Ukraine, to the renewed lockdowns in China. “We’re going to have to be humble and skeptical about forecasts,” he remarked.
Still, Powell also sketched out a positive scenario in which inflation gradually comes down throughout 2023, the economy manages to avoid a recession, and the unemployment rate doesn’t rise drastically. Referring to prior periods when the Fed raised interest rates sharply, he conceded, “If you look at the history, it’s not a likely outcome.” However, he added, “But I would just say this is a different set of circumstances.”
It certainly is. More specifically, the pandemic prompted many workers to retire or drop out of the labor force, and yet, largely because of supportive government policies, the pandemic shock didn’t lead to a lasting slump in hiring and spending. Consequently, the number of job vacancies has been running far above the number of unemployed people seeking work, and this remains true. Hours before Powell spoke, the Labor Department released figures for October that showed job openings across the country totalling 10.3 million, compared with 6.1 million people officially classed as unemployed.
The Fed’s fear is that this large gap between job openings and job seekers is putting upward pressure on wages, which is causing inflation to spread from goods (think of new cars, or electronics imported from China) to the service sector (think hotel rooms, or meals at restaurants). In Powell’s best-case scenario, which he laid out clearly, a slowing economy will cause the imbalance in the labor market to resolve, mainly through a decline in job vacancies rather than an increase in layoffs and unemployment. Pointing to a gradual fall in vacancies during the past few months, Powell said there was some evidence that this was happening, but cautioned that it was too early to say whether the trend would continue on the scale necessary to defeat inflation.
The negative scenario for 2023 and 2024 is that the cumulative impact of the Fed’s rate hikes on interest-sensitive sectors of the economy—such as real estate, auto sales, and many types of finance—will eventually push the entire country into a recession, in which employers lay off workers en masse and the unemployment rate rapidly rises. When Powell was asked whether he agreed with the Fed’s own research staff, who recently said that a recession is now almost as likely as a non-recession, he resisted handicapping the outcome, but added, “I do continue to believe that there is a path to a soft, or soft-ish, landing.”
If Powell does achieve his goal, it would obviously be advantageous to Joe Biden and the Democrats, who would much prefer to go into the 2024 election year with the economy growing healthily and the inflation spike in the rearview mirror. Judging by the bounce in the stock market, many investors think that such an outcome is possible. In recent months, the rate of inflation has started to decline, a move confirmed by new figures that the Commerce Department released on Thursday, which showed “core” inflation—excluding energy and food prices—running at five per cent year over year in October, compared to 5.2 per cent in September. Many economists are expecting further falls in the months ahead, and Wall Street is already looking ahead to when the Fed starts cutting interest rates. That’s why investors have been rushing back into the stock market.
Ironically, however, if Wall Street continues its premature celebration of a Fed victory in the struggle to tame inflation, this could make Powell’s job more difficult, not easier. When he and his colleagues raise or lower interest rates, their action impacts the economy in two stages. In stage one, the financial markets react, with asset prices, market interest rates, and credit spreads all moving rapidly, often even in anticipation of a policy change. Then, in stage two, this change in financial conditions gradually courses through to the rest of the economy. A higher federal funds rate pushes up mortgage rates, which hits home buyers. A falling stock market can impact consumer spending and business investment.
The potential problem is that when the stock market goes up and long-term interest rates decline—two things that have both happened in the past month or so—financial conditions get easier, not tighter, thereby undercutting the Fed’s efforts to slow the economy and curb inflation. If these trends go on, Powell and his colleagues could be tempted to keep the federal funds rate higher, and for longer, than would otherwise be the case. This, in turn, means an eventual recession would be more likely, not less likely.
In other words, the Fed is playing in a kind of high-stakes game with Wall Street even as it engages in an even higher-stakes effort to manage the economy as a whole and avoid a recession. On Wednesday, Chair Powell gave investors something to chew on. If the Wall Street piranhas get overexcited, he may well have to put them back on starvation rations. ♦