If the US economy slips into recession in the second half of the year, as most forecasters expect, the Federal Reserve says it will make some tough love in lieu of a lifeline.
There’s a good chance the Fed will halt its aggressive rate hikes, but it has indicated repeatedly that it probably won’t cut rates this year, even in a mild recession, because it wants to subdue the historic inflation rally.
The reaction of the financial markets and some economists is laconic: bullshit.
Markets expect the Fed to cut rates by November and give odds of 30% that it will make a move in September.
“They’re not going to stick to their guns,” says Joe LaVorgna, chief US economist at SMBC Group and a former economic advisor in the Trump administration. “There’s no way they can sit back and watch (employment) go down” as job losses mount.
LaVorgna points to past recessions, noting that the Fed usually reverses course from fighting inflation to trying to quickly avoid or reduce deflation as the economy weakens, apparently contradicting itself. Since the 1950s, LaVorgna says, the average time lag between the last rate hike and the first cut has been just two months.
Interest rate cuts would boost the stock market and the economy, but risk another spike in inflation.
Risks of the 11-hour debt limit dealA last-minute deal on the debt ceiling could still trigger a recession even if the US avoids default.
How far has the Federal Reserve raised interest rates recently?
The Fed raised its main interest rate by a quarter of a percentage point early this month, capping off five points of increases in 14 months, its most aggressive campaign in four decades. Federal policymakers projected that easing would not begin until late January at the earliest, even in the mild recession Fed staffers expect this year. This is nine months late. Such a tough stance in the face of large-scale layoffs would be highly unusual.
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How does raising interest rates help the economy?
This time is different, says Jonathan Millar, former chief economist at the Fed, 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 Reserve’s target. Fed’s 2%. . Fed Chairman Jerome Powell said that it is more important to eliminate inflation so that it does not become entrenched in the nation’s psyche, as it did in the 1970s, than to avoid mild deflation, which can be cured by lowering prices.
Higher interest rates make it more expensive for consumers and businesses to borrow, which dampens spending and prompts businesses to keep rates steady or raise them slightly. But the Fed’s wave of rate hikes is also expected to be the main trigger for any recession.
To a large extent, the Fed’s strategy is rooted not only in its actions but in its promises to raise interest rates or keep them high because such rhetoric can influence consumers’ inflation expectations. If workers believe prices will continue to rise, they are more likely to demand a wage increase, a cost that firms may offset by pushing prices higher.
“We have a view in the committee that inflation is going to come down — not that fast, but it’s going to take some time,” Powell said at a news conference this month. “And in this world, if these predictions are generally correct, it would not be appropriate … to cut interest rates, and we will not cut interest rates.”
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Will the Fed cut interest rates soon?
Powell suggested that if inflation falls more quickly, as some economists expect, the Fed could lower interest rates. It is also possible that the collapse of Silicon Valley Bank and other banks will continue to threaten regional banks if many customers withdraw deposits, accelerating the decline in lending. That could lead to a deeper slowdown and lower inflation more quickly — either of which could lead to the Federal Reserve cutting interest rates within months, economists say.
“Chair Powell at the moment does not want to talk about (cutting prices),” Ian Shepherdson, chief economist at Pantheon Macroeconomics, wrote in a note to clients. “But that will change. The Fed will do what the data tells them, and the data will go south.”
LaVorgna believes the Fed will cut interest rates this year in part because the recession will be more severe than the Fed expects. But he says the Fed will change its stance even if there is a mild to moderate downturn, as he expects, with the unemployment rate rising from the current 3.4% to 4.5%.
“Normally the Fed is not very good at knowing when it is going to pivot,” says LaVorgna.
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How did the Federal Reserve respond to the Great Recession?
In August 2007, the housing crisis that would trigger the start of the Great Recession later that year was already brewing. Many low- and moderate-income homeowners were defaulting on their subprime mortgages and banks began to restrict lending.
Then-Fed Chairman Ben Bernanke noted the financial pressures 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 still sees “risks” from inflation. And while inflation fell to 2.4% in July from 4.1% a year earlier, Bernanke agreed with colleagues who believed the improvement could be temporary and that low unemployment (4.6%) could push wages and prices higher.
“I agree with those who still see the risk of inflation being tilted to the upside,” Bernanke said.
In its statement after the meeting, the Fed held interest rates steady, saying “the continued moderation in inflation pressures has not yet been convincingly demonstrated.”
Just three days later, the Fed lowered the discount rate, citing “turmoil in the money and credit markets,” LaVorgna noted. At its meeting in September, the central bank cut the federal funds rate by half a percentage point, after that with quarter-point cuts in October and December.
“I am concerned about getting ahead of what could be an adverse dynamic between the labor market and the housing market,” Bernanke said at the September meeting. “On inflation, I think the slowdown that we are likely to see will probably remove some of the upside risks that we were worried about.”
The Fed’s current stance is “eerily similar,” LaVorgna said, referring to the current problems of regional banks.
However, Millar says the Fed’s dilemma in 2007 was different. The 2007-2009 financial crisis was far more damaging because it affected the country’s largest banks, which were tightly interconnected and heavily curbed lending. Regional banks don’t have a significant impact on the broader economy, Millar says, though an escalating crisis that spreads to more regional banks could further hurt lending and growth.
It also notes that inflation, at 4.9%, is now twice as high as it was in 2007, making the Fed’s decision to cut easier at that time.
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What happened in the 1990-1991 and 2001 recessions?
Inflation also rose in July 1990 and January 2001 at 4.8% and 3.7% respectively, and the Fed had kept rates unchanged at historically high levels. But as the economy began to wobble amid soaring rates — along with the spike in oil prices in 1990 and the dotcom crash in 2001 — the Fed quickly changed course and began to snap.
On November 15, 2000, the Federal Reserve indicated that higher energy prices could raise inflation expectations even as demand for homes and businesses subsides. It kept interest rates steady, adding that “risks remain fundamentally weighted towards conditions that may generate increased inflationary pressures…”
By January 3, the Fed had changed its tune, cutting its benchmark rate by half a percentage point before losing 20,000 jobs that month. He noted “further weakness in sales and production… and higher energy prices reduce the purchasing power of households and businesses. Moreover, inflationary pressures remain contained.”
Says Millar, “Inflation wasn’t as much of an issue then as it is now. So it was an easier choice for them.”
However, LaVorgna believes that a weak job market with tens of thousands of job losses per month could lead to a Fed shift.
“When the economy collapses, they will be under tremendous pressure to do something about it,” he says.
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