Despite the uncertainty posed by the war in Ukraine, Federal Reserve Chair Jerome Powell said Tuesday that the U.S. economy was strong enough to withstand interest rate hikes without slipping into a recession. But his other remarks were surprising.
The Federal Reserve moved to increase interest rates by a quarter percentage point on Wednesday and plans to implement multiple hikes throughout the year to reach a rate of 1.9% by the end of 2022. The central bank is upping rates in an effort to slow down consumer demand.
As the Fed raises interest rates, that should gradually slow down demand for the interest-sensitive parts of the economy, such as mortgages and auto loans on the consumer side and loans and financing on the business side. That in turn should help stabilize runaway inflation, the annual rate of which rose by 7.9% last month. “What we would see is demand slowing down, but just enough so that it’s better matched with supply, and that will bring inflation down over time,” Powell explained.
“Our intention is to bring inflation back down to 2% while sustaining a strong labor market,” Powell said.
But if anything, he said the labor market is too strong. Powell noted that the U.S. currently has about 1.7 jobs available for every unemployed person. “That’s a very, very tight labor market—to an unhealthy level,” he said. It’s a situation in which consumer demand is higher than the labor and production supply. And when that happens, prices go up.
So here’s how Powell explained what the Fed plans to do.
The Fed threading the needle, or trying to
It’s a tricky needle to thread, since companies and consumers going without credit could lead to a sudden slowdown and even a recession. But Powell said Wednesday that he believed the labor market and consumer conditions were strong enough that a recession was unlikely.
“The probability of a recession within the next year is not particularly elevated,” Powell said. “Aggregate demand is currently strong, and most forecasters expect it to remain so.”
Experts have warned about the Fed’s difficult path forward, noting Russia’s invasion of Ukraine complicates the situation. “This is the Fed’s worst nightmare,” Diane Swonk, chief economist at accounting firm Grant Thornton, recently told Fortune. Fed officials were counting on oil prices continuing to slide and supply-chain bottlenecks easing enough to send the prices of goods tumbling to help alleviate the inflationary pressure in conjunction with rate hikes. But the conflict has likely scuttled those outcomes.
But others agree with Powell that the U.S. economy can handle the rate hikes without risking a recession this year. “I agree with Powell that the risks aren’t particularly elevated for 2022,” PNC chief economist Gus Faucher told Fortune. “The fundamentals that he mentioned in his press conference are solid positives for this year: good job growth, wage gains, very strong consumer balance sheets, etc. And the impact from rate hikes will be small this year given that the Fed will move incrementally, and monetary policy works with a lag.”
Recession risk
Yet Faucher doesn’t rule out a recession down the line, saying the risk of a recession will be elevated in 2023 given that job growth will likely slow. PNC estimates the chance of the U.S. entering a recession is around 30% over the next couple of years. The team’s estimated probability doubled after the Ukraine invasion.
“The most likely outcome is still that the Fed engineers a gradual slowing in inflation over the next couple of years while growth continues, although with a few bumps along the way,” Faucher said.
“There’s a misalignment of demand and supply particularly in the labor market,” Powell said. That’s happening as the average wage is increasing dramatically, which could lead to a wage-price spiral, where rising wages lead to an increase in prices.
“Wages moving up is a great thing. That’s how the standard of living rises over time, and it’s generally driven over long periods by rising productivity,” Powell says. And while it’s a good thing in some respects, Powell said that “it wouldn’t be sustainable over too long of a period to see that moving up that much higher.”
He did note, however, that he didn’t see a wage-price spiral getting to the point of being entrenched in the U.S. economic system.
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