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The US Federal Reserve may get a little cocky this week as the rate-setting committee meets for the last time before the summer recess. Annual inflation in America slowed to just 3 percent in June, the lowest level since March 2021. It fell below traditionally inflation-ridden Japan, with price growth of 3.3 percent. Perhaps most impressively, the unemployment rate has barely increased and the odds of a recession are declining, despite the Fed’s 500 basis point interest rate hikes over the past 18 months.
Can President Jay Powell really implement a “pure purge of inflation” for the US economy? If he does, it will make him one of the most successful Fed chairmen. Even the lauded Paul Volcker — famously for raising interest rates to 19 percent in the early 1980s — ended up pushing American unemployment to its highest levels since the Great Depression.
Goldman Sachs now only sees a 20 per cent chance of a recession in the US over the next year. Economic activity is elastic. Consumer confidence this month reached its highest level in two years. Markets are expected too. A slew of US stocks rebounded, not just tech companies. But a “soft landing” – when inflation is lowered without causing significant deflation – is by no means guaranteed.
For starters, interest rates may still need to go up. Investors expect a rise of 25 basis points this week. The Fed’s “dot plot” of committee members’ rate expectations also suggests other forecasts this year. The drop in inflation last month to a two-year low was largely attributed to lower energy prices, and core inflation remains more than double the 2 percent target.
Crushing demand further to pull price pressures down would lead to more job losses. Job openings have decreased, but the job market still looks strong with strong wage growth. The Fed may face a difficult trade-off between its dual mandate to maximize employment and price stability as the target approaches. Indeed, the Bank for International Settlements says the “last mile” of the deflationary process may be the hardest.
Nor is it clear precisely how quickly past Fed rate hikes have already passed through to the real economy, and will continue to do so. The Kansas City Fed recently said that a peak deceleration in inflation could occur after a year of tightening, but added that uncertainty is high around that estimate. Either way, most economists agree that much of the price hike has yet to be felt. This could lead to a lower growth rate than currently expected.
Post-pandemic idiosyncrasies also partly help explain the strange trifecta of high rates, low inflation and limited unemployment. Fading savings and fiscal support supported demand, while a shift in spending from durable goods to services eased some of the price pressures. The scenario of a clean sweep will depend on how these factors come into play as well.
Soft optimism is not just an American phenomenon. Some emerging markets that raised interest rates before the advanced economies have already managed to bring down inflation without hurting output excessively. Hopes are high in the European markets now, too. Inflation in both the Eurozone and the United Kingdom took a notable downward step last month, and their economies showed some resilience. But it’s worth noting that in this uncertain climate, the pendulum swings between soft and hard landing scenarios more frequently.
Indeed, while it is undeniably positive that inflation in the US and around the world is declining, this post-pandemic interest rate cycle is bizarre enough to give investors banking on the soft landing plenty of pause for thought.
