All signs point to a coming recession
The US economy seems headed for a recession later this year or early next year. A recession would make clear that the new monetary policy strategy the Federal Reserve announced in August 2020 has been a failure.
The Fed’s new strategy represented a break with the approach it had adopted in response to The Great Inflation of 1968-1982, when inflation eventually soared above 10 percent. Although oil price shocks contributed to the Great Inflation, most economists believe that Fed policy failures were the reason the inflation was so severe.
The Great Inflation taught the Fed that monetary policy should preempt increases in inflation before they became embedded in the economy. Changes in monetary policy can take a year to have their full effect, so the Fed needed to begin raising interest rates when the unemployment rate dropped below the so-called natural rate of unemployment, even if inflation had not yet begun to accelerate. The Fed was still following this approach in 2015, when it raised its target for the federal funds rate even though its preferred measure of inflation was still below its 2 percent target.
By July 2019, a majority on the Fed’s Federal Open Market Committee had come to believe that with no sign of inflation accelerating, they could safely cut the federal funds rate. The formal change came in August 2020 when they announced that they were adopting a flexible average inflation target (FAIT). Rather than viewing 2 percent as effectively a ceiling on inflation, they now would allow inflation to rise above 2 percent provided that it averaged 2 percent over an unspecified period. They also would no longer focus mainly on the unemployment rate in assessing the state of the labor market.
There are two key problems with the Fed’s new monetary policy strategy. First, it’s unclear by how much inflation can exceed the 2 percent target or for how long it needs to stay there before the Fed will react. Second, by waiting until it has exceeded the 2 percent target, the Fed has abandoned the decades-long policy of preempting inflation.
It seems unlikely that inflation can be brought down to 2 percent until the real federal funds rate becomes positive. While rapid increases in interest rates should succeed in reining in inflation, they are also likely to cause a recession. As Atlanta Fed President Raphael Bostic has noted, in every similar case since 1960, when the Fed has had to respond to a rapid increase in inflation, the result has been a recession.
The new monetary policy strategy the Fed adopted in August 2020 has left it without good options. It can follow the present course of slowly increasing interest rates, which will allow high inflation to persist for at least the next two years, or it can increase rates more rapidly, which will bring down inflation, but likely push the economy into a recession.