What will it take to break inflation?
It wasn’t terribly long ago that the hope – indeed, the assumption – of both Treasury Secretary Janet Yellen and Federal Reserve Chairman Jerome Powell was that it would take essentially nothing to rein inflation in. That’s because each of the co-managers of the world’s largest economy were of the opinion for much of last year that inflation would be “transitory.”
They were both wrong, of course. And the biggest consequence of Yellen and Powell being so wrong for so long about inflation is that higher prices had ample opportunity to dig themselves deep into the fabric of the economy. By the time the Federal Reserve finally got around to hiking rates – not until March of this year, mind you – the consumer price index (CPI) was all the way up to 8.5%.
Now, however, the central bank’s position on inflation now is about 180 degrees from where it was last year. And in his speech delivered at the Fed’s recent economic policy symposium in Jackson Hole, Wyoming, Powell used the opportunity to emphasize that bringing down inflation has become “job one” – whatever the fallout.
“The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal,” Powell said. The chairman informed us all that we should expect the application of “forceful and rapid steps to moderate demand.”
And he finally said what he’d been trying very hard to avoid saying for so long: that to get inflation back down to that 2% range is going to come at a significant cost.
“While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses,” Powell said. “These are the unfortunate costs of reducing inflation.”
Noticeably absent from Powell’s remarks was any talk of “soft landings.” It appears that ship has indeed sailed. Inflation remains stubbornly above 8%, and there now is talk the next Fed rate hike could be as much as 100 basis points.
Let’s set aside the fact that plenty of Americans surely would say they’ve been feeling plenty of pain already at the hands of the inflation that Powell and his colleagues allowed to take root. Just how additionally “painful” might conditions become going forward?
Here’s one projection – and it’s rather ugly: According to a Brookings Institute research paper assembled by a Johns Hopkins economist and two economists at the International Monetary Fund (IMF), unemployment will have to climb to more than double its present level to relieve present price pressures.
Chairman Powell wasn’t kidding – that is painful.
It remains to be seen if unemployment will, in fact, have to get that high in order to bring consumer prices back in line. But given how thoroughly entrenched inflation has become and how devoted the central bank now (finally) appears to be to rooting it out, it’s reasonable to consider we’ll see the jobless number surge higher before the mission is accomplished. And as we will see shortly, these three economists are not the only ones who contend that unemployment will have to climb much higher to lasso consumer prices.
The economists – Laurence Ball of Johns Hopkins along with Daniel Leigh and Prachi Mishra of the IMF – have determined through their analysis that the headline unemployment rate may have to reach a jaw-dropping 7.5% in order for inflation to be driven back into its cage. That translates to roughly six million Americans losing their jobs.
Excluding the pandemic, the unemployment rate hasn’t been that high since 2013, when the nation was continuing its fight back to normalcy through the fallout from the financial crisis.
According to Ball, nothing short of “quite optimistic assumptions” about the near-term future of inflation and the job market would be required in order for the unemployment rate to be lower and for inflation to still subside.
The Federal Reserve’s unemployment projections from June reveal that central bankers expect to see median unemployment at 3.9% next year and at 4.1% in 2024 – and that inflation will be back in the 2% range both years. Obviously, this is a far more optimistic outlook than the referenced research suggests will be required to strike down inflation.
“If either the labor market doesn’t behave, or (inflation) expectations don’t behave, the small increase in unemployment the Fed projects won’t be enough,” Laurence Ball said. “Either inflation will stay substantially higher, or we will have higher unemployment and a substantial economic slowdown.”
In the paper, Ball and his colleagues flatly said that “a painful and prolonged increase in unemployment” will be required to get inflation back down to where the Fed envisions it by 2024.
It should be noted that the Fed’s more subdued projections came roughly 2½ months before Powell delivered his now-famous “pain” speech at Jackson Hole. As recently as the end of July, the Fed chairman was still referring to the prospect of a “soft landing” in a hopeful tone. But as I said earlier, no such mentions were made last month at the Fed’s economic symposium.
It appears to be full steam ahead, then, in the Fed’s effort to catch inflation. And if you think the prospect we’ll see 7.5% unemployment as a part of that effort is just an “outlier” projection, it might interest you to know that a former Secretary of the Treasury also thinks that’s exactly what it will take to get inflation under control.
Larry Summers, Secretary of the Treasury under President Clinton, is not mincing words in his assessments of what he says it will take to beat back inflation once and for all. Summers said recently “that bringing inflation down to 2% will likely require a significant recession.” And one characteristic of that “significant recession” projected by Summers? The same severe level of unemployment that Laurence Ball and his colleagues say is a “must-have” to get the job done.
In June, Summers was in London delivering a speech in which he sharply contradicted the Fed’s projection of how little unemployment would be required to get inflation back down to the 2% range.
“We need five years of unemployment above 5% to contain inflation—in other words, we need two years of 7.5% unemployment or five years of 6% unemployment or one year of 10% unemployment,” Summers said at the time.
“There are numbers that are remarkably discouraging relative to the Fed Reserve view,” Summers added.
In his speculation about what the Fed might have to do this time to effectively fight inflation, Summers even went as far as to invoke the ghosts of that period in American economic history known as the “Great Inflation.”
“The U.S. may need as severe monetary tightening as Paul Volcker pushed through in the late 1970s, early 1980s,” Summers said. The former Treasury secretary was referring to a rate-tightening cycle overseen by then-Fed Chairman Volcker that saw rates come close to 20% in an effort to bring down the inflation that itself was close to 15%. During the recession that ensued from July 1981 to November 1982 when lofty rates clashed with high inflation, unemployment ultimately reached nearly 11%.
To clarify, Summers isn’t saying it will take the same sky-high rates the economy suffered through in the early 1980s to reduce inflation this time around. What he is saying, however is that it will require the same degree of Fed boldness and decisiveness – something to which Americans aren’t at all accustomed to in 2022.
Let’s talk a little about that.
Even as credible projections of much-higher unemployment mount, there likely will be those who find it difficult to accept the possibility that a headline jobless number which looks so good right now could turn so ugly in the relatively near future.
For those who are inclined to both hope for the best and plan for the best, I’d like to remind you that the condition of the economy met the “technical” definition standard of recession as of June 30. That date marked the end of the second consecutive quarter of negative GDP.
We know that National Bureau of Economic Research (NBER) looks at more than just consecutive quarters of negative GDP when weighing official declarations of recession. But we also know this: Prior to the current economic cycle, there have been 10 instances of consecutive quarters of negative GDP since 1948, and each of those corresponded to an eventual recession declaration by the NBER.
Here’s my point: Yes, the current headline unemployment rate is low. However, that low unemployment rate happens to exist right now against a backdrop of economic output that’s strongly suggestive of recession. So, how likely is it that the country could see the unemployment rate double from here and not coincide with an especially deep downturn?
There’s nothing wrong with hoping for the best. I’m doing that myself. But let there be no misunderstanding about my position: Given what we know our country went through during pandemic-riddled 2020 as well as the financial crisis – and in light of the continued deterioration of our current economic outlook – it seems wrongheaded that retirement savers would leave their nest eggs unprepared out of deference to indulging in pleasing, wishful thoughts.
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