The way forward will come more clearly into focus on Tuesday when the Labor Department reports January CPI, which is likely to show that inflation has fallen for the seventh straight month. In the second half of 2022, it was below 3 percent on an annualized basis – an encouraging trend.
With job growth surging and wage increases flattening, there is now more hope than there has been in almost a year that the economy can slow along with inflation without a painful recession – a so-called soft landing. But prices have still risen faster in the last year than they have in four decades, and Powell says he will do whatever it takes to keep borrowing costs high and prevent price hikes from becoming a more permanent feature of the economy.
“We’re in an economy right now that obviously has some bright spots and dark spots, with inflation still on the downtrend,” said Tobin Marcus, a senior policy and policy strategist at Evercore ISI, who was an economic adviser at the time. Vice President Biden. “The President is more interested in highlighting the bright spots, for very clear reasons, while Powell still needs to focus on the need to finish the job.”
So, if inflation is close to the Fed’s 2 percent target rate even amid a hot labor market, why does the central bank feel the need to repeatedly warn that it is prepared to keep raising interest rates and risk a recession? Inflation is a complicated beast, and there’s a lot of history here.
Here are five key questions about what’s going on with consumer prices and what could be in store for the economy, Biden and Powell.
You said the job market is booming. Why do I keep reading about how a recession could happen?
The Labor Department recently reported that unemployment was 3.4 percent, its lowest level since 1969. The only time it was lower in modern US history was during the Korean War. It’s an ideal braggart for Biden, who has since touted his career record in his annual State of the Union address and on trips. But Powell is watching low unemployment with concern that it could send wages skyrocketing, driving up labor costs for employers and hence prices — the so-called wage-price spiral.
For the Fed, inflation matters, but the job market is a key signal of where prices could be headed. The demand for goods and services creates jobs and also gives people money to spend. That said, a very strong labor market is a sign that consumers and businesses will be able to support rising prices.
Basically, the Fed is willing to risk a recession if it means avoiding what happened in the 1970s – when the central bank backed away from raising interest rates and inflation repeatedly returned with a vengeance. Basically, the logic is this: we know how to deal with recessions. Killing inflation is harder. So, it’s better to side with hyperbole, because you can always change course and lower the cost of borrowing.
Does the Fed really have to hurt the job market to bring down inflation?
That’s the multi-trillion dollar question. Many pundits would say no, pointing to idiosyncratic factors – supply shortages, government spending, Russia’s war in Ukraine – that have fueled this inflationary spurt and cannot be cured by higher interest rates. Certainly, to the extent that inflation has cooled, a large part of it is the fading of these temporary factors.
But if inflation doesn’t continue its downward trend, Fed officials will hike rates higher, or maybe just want to keep them at punitive levels longer until they see what they call a slowdown in the jobs market – fewer job openings, slower wage growth and most likely slightly higher unemployment.
Wait, did you say that inflation has been just over 2 percent for the last six months? Isn’t that the Federal Reserve’s goal? Are you almost done?
Yes, the Fed’s target is 2 percent inflation, but no, they’re not done yet. A big reason why price spikes have come down so much is because of gas prices, which are volatile and driven by global circumstances. Powell and his colleagues want to be sure that inflation is cooling across the board. Prices of goods like furniture and cars have fallen, while rents may slow their rise. But for the Fed, rising prices are still a problem in core service businesses (think restaurants, transportation, healthcare) where labor costs are a big expense. In the last six months, prices there have risen by 4.7 percent.
So this is where wages come into play. Are wages growing faster and faster?
No, wage growth is not accelerating. But Fed officials and other economists think workers’ wages, which rose about 5 percent in 2022 (compared to a 6.5 percent increase in CPI), are still rising too fast for inflation to return to a sustained level could return to 2 percent. For comparison, wages were growing at about 3.5 percent annually before the pandemic, when inflation was just under 2 percent.
There’s an argument that the Fed needn’t be too concerned because incomes will simply rebound after being hit by inflation, and workers will stop pushing for such large hikes once price spikes are more under control. But the fact that the unemployment rate is so low has the Fed concerned that labor shortages will shift that trend. At the very least, they would like to see a reduction in job openings.
All of this doesn’t seem to bode well for 2024, and for anyone trying to get re-elected then.
Yes, the Fed chair has indicated that unemployment could rise by a percentage point or more as the central bank continues to raise borrowing costs to curb spending. Tension between the state of the economy and possible direction has eased sharply in recent days: Both Biden and Powell want to lower inflation, but the Fed is likely to undermine one of the president’s biggest selling points through 2024.
“I believe both [Biden] and Powell would order the same items off the menu,” said Jason Furman, who served as former President Barack Obama’s chief economist. “But they think the menu is very different, with POTUS seeing the soft landing as a point that’s written on it, while Powell is a lot less sure it is.”
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