Scare or die: The Fed faces a dilemma not seen in recessions in the last 40 years

The US economy is facing a drastic slowdown. The big question now is whether the Fed and the Joe Biden Administration will be able to pilot a soft landing or if the crash (recession) is already inevitable. If the US economy ends up contracting, the Federal Reserve will face a sticky scenario. The labor market will suffer the consequences and the Fed will have to prioritize or choose between one of its two mandates: row one way and maintain full employment or row the other and try to bring inflation down to target. Get both in a scenario of quasi stagflation seems like an impossible mission.

The recession drums are beating louder and louder in the US economy. So much so, that the president, Joe Biden, spoke by phone this week with Larry Summers, a former Treasury secretary and respected economist, who knew how to anticipate the inflation crisis and now foresees the arrival of a recession. Biden assures that his talk with Summers has concluded that the recession is not inevitable.

However, when non-government agencies are asked, the scenario of a soft landing seems increasingly distant. The Federal Reserve has already stepped on the accelerator of rate hikes to curb inflation that has gone too far (8.6%). The accident seems inevitable.

An earlier and more severe recession

The economists of Deutsche Bank (one of the first institutions to include the recession in its base scenario) have published this Tuesday an update of the economic forecasts for the US and the news is not good: “More than two months ago, we forecast that the economy The US economy would enter a recession at the end of 2023. Since then, the Fed has embarked on a more aggressive route, financial conditions have tightened dramatically and economic data is starting to show clear signs of slowing down.In response to these developments, we now expect a earlier and somewhat more severe recession.

These experts forecast GDP growth of less than 1% in the first half of 2023 and that the first contraction in activity will occur in the third quarter of 2023, one quarter earlier than the previous forecast. “The economy is likely to contract next year by about 0.5%. A more severe recession will lead to a higher unemployment rate, peaking near 5.5%.” However, from Deutsche Bank (DB) warns that this forecast runs the risk of materializing before and terminate by short-circuiting the up cycle of Federal Reserve rates.

The Fed’s roadmap

If everything goes as expected in the baseline scenario (the economy does not start to contract until the third quarter of 2023), “the Fed will raise rates by another 75 basis points (bps) in July, followed by two increases of 50 bps in September and November, to change to a more moderate pace of 25 bps in December”.

Furthermore, DB analysts believe that to ensure a sufficient tightening of financial conditions and a positive real federal funds rate next year, we believe that Fed-managed rates will likely end up above 4 % in this cycle, approximately 50 bps more than when we announced the recession in April.

And when does the recession come?

When the economy begins to slow down, the labor market will begin to destroy jobs. This will help curb inflation, “although we still anticipate a nearly half-point excess in core PCE.” Then, the Fed will face a real puzzle. Inflation will remain above target, while the labor market will be moving away from full employment. This is the nightmare of any central bank.

“Based on our baseline scenario, the Fed will face a clear tension in responding to this recession, a tension that has not been present during the recessions of the last four decades. With core PCE inflation (the Fed’s fetish price gauge) above 3.5% and the economy entering a recession, it may be limited in cutting interest rates to support growth and the market labor”.

It’s a powerless situation for the Federal Reserve. On the one hand, inflation will remain above the target (2% in the medium term), which should force Jerome Powell and his team to keep interest rates high (to cool demand). But on the other, the labor market will be far from full employment (second term), which in principle would force the central bank to lower rates. This is a puzzle the Fed hasn’t faced since the late 1970s. The recessions of the last 40 years have been simpler (all you have to do is pull a monetary lever), at least from a central bank’s point of view.

“Our core belief is that with inflation by then on a clear downward trajectory and the unemployment rate rising at a fast pace and well above the long-run natural rate, the Fed could choose to cut interest rates modestly to change monetary policy. As such, we see the Fed cutting interest rates by 150 basis points in the second half of the year, leaving the fed funds rate at 2.6% by the end of 2023. The rate cuts are likely to be accompanied by the end of balance sheet reduction”.

However, if inflation remains higher than expected, with core PCE at 4% or higher, the Fed could face an even bigger problem: “With core PCE inflation well above 4%, its ability to respond to the recession through rate cuts will be even more limited,” these experts say. Although the Fed is in a more comfortable position than the European Central Bank, Jerome Powell will also have to make decisions that will not please everyone and that, above all, may have a negative impact against one of his mandates: full employment or inflation.


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