The Federal Reserve is about to attempt a feat it has arguably achieved just once before in its modern history. At the risk of sounding a little dramatic, whether it succeeds or fails may well determine the fate of Joe Biden’s presidency.
The mission? Bring down inflation without accidentally tipping the U.S. into a recession. With consumer prices rising at their fastest pace since the early 1980s, the Fed will try to slow them back down by raising interest rates in the coming months. Chairman Jerome Powell has said that he and his colleagues will likely begin to hike rates starting in March. Investors and financial reporters are buzzing with speculation about just how aggressively the Fed might move, with some wondering if we are about to witness the monetary policy equivalent of a “shock and awe” campaign.
Publicly, Powell has said he is confident the Fed can quell inflation without causing unemployment to spike or growth to plummet. “I think there’s quite a bit of room to raise interest rates without threatening the labor market,” he told reporters last week. But a number of economists aren’t convinced. They point out that historically, once inflation has started to gallop out of control, the Fed has almost never been able to rein it back in without triggering a downturn.
“There have been few, if any, instances in which inflation has been successfully stabilized without recession,” former Treasury Secretary Larry Summers wrote in a December Washington Post op-ed.
Summers and his fellow skeptics have differing views of what our central bankers should do, but are united in their pessimism about what’s likely to happen. Some, including Summers, are inflation hawks who believe that Powell and his colleagues should have acted sooner to slow prices and now have no choice but to play catchup, even if it risks a recession, lest consumer prices skyrocket further out of control.
Others are doves, who think hiking now poses a needless risk to the economy. They would prefer the Fed to wait and see if inflation eventually settles on its own.
One such voice is John Jay College economist J.W. Mason, who recently argued in Barron’s that the Fed simply isn’t capable of fine-tuning inflation. “Larry Summers has said a lot of things I disagree with recently,” Mason told me. “But one thing he’s said that I do agree with is that there’s no reason to think the Fed can engineer a smooth landing. They either provoke a recession or don’t do much of anything at all.”
The Fed critics’ biggest cause for pessimism is simply the historical record. Since the 1950s, almost every major inflationary episode in the United States has ended with an economic downturn after the Fed tightened monetary policy. The most famous example occurred during the early 1980s, when the Fed under Chairman Paul Volcker managed to get the CPI on a leash only by dragging the country through a severe double-dip recession that saw unemployment top 10 percent. But there are also cases from the 1950s, ’60s, and mid-’70s. When the Fed launches an all-out war on inflation, the economy is typically a casualty.
As University of Oregon professor Tim Duy put it to me: “Has [inflation] ever really reverted without some sort of Fed action that triggers a recession? I would say that within any reasonable time span, the answer is no.” You don’t get many “damned if you do, damned if you don’t” scenarios clearer than that—at least if you’re a president asking voters for a second term.
When optimists reach for inflation-fighting counterexamples, they typically cite Alan Greenspan’s famous “soft landing,” when he doubled interest rates from 1994 to 1995 to keep a lid on inflation while nimbly avoiding a downturn. At the time, the effort was considered a triumph of monetary policymaking and helped cement his reputation as the “maestro” of central banking.
But Greenspan was operating under very different circumstances than the Fed is today. Most importantly, inflation wasn’t actually accelerating when he began to raise interest rates in 1994; rather, Greenspan decided to start hiking as a preemptive strike against inflation, because he believed the financial markets were signaling that it might be about to speed up. Dealing with inflation once it has already flared—as it has since March of 2021—is a very different matter.
There might be one instance in which America’s monetary policymakers did in fact restrain inflation after it started to surge without also tanking growth—but you have to dig far back in time to find it. The moment occurred in March of 1951, when the Fed’s leaders won a dramatic public showdown with the White House over what role the central bank should play in managing the economy, resulting in an agreement known as the Treasury-Fed Accord. The deal essentially birthed the modern, independent Fed, by giving it political room to fight inflation using interest rates even if it made borrowing more expensive for the government. At the time, consumer prices were soaring thanks to the Korean War. After the agreement, inflation quickly fell without an immediate recession. “There is no other case where inflation actually exists in the data, and it’s more than 4 or 5 percent, and you got it down without having a recession,” Gary Richardson, a former Fed economist and professor at the University of California, Irvine told me.
Unfortunately, it’s not crystal-clear what caused inflation to drop that year, or if the Fed was entirely responsible. New price controls the Truman administration announced that January likely played some role, as did the fact that Americans stopped panic buying goods when they realized there weren’t going to be new wartime shortages. Meanwhile, the U.S. did eventually fall into a recession as the Fed allowed long-term interest rates to rise in 1953. If you want a tidy historical precedent for what the Fed is hoping to pull off today, you’re out of luck.
Why is it so hard for the Fed to fight inflation without bringing about a recession? One standard answer boils down to psychology. Most economists believe that inflation in the present is in large part determined by what people expect inflation to be in the future: If a business owner thinks prices will rise quickly, for instance, she’ll hike her own in anticipation.
Once the public becomes convinced inflation is here to stay, the thinking goes, it requires a major shock to the economy to convince them otherwise, like a recession that forces prices down. (Of course, because nobody agrees on anything in economics anymore, there are some who don’t think expectations necessarily matter at all.)
Another less orthodox theory is that interest rates just aren’t a very nimble tool for managing the economy. In order to slow inflation at all, the Fed has to raise them so high that it crushes consumer demand. In this view, interest rates are a bit like a light switch without a dimmer; you can use them to flip growth on or off, but not tweak it to just where you’d like. Or, as Mason recently wrote, “being able to sink a ship is not the same as being able to steer it. The fact that the Fed can, if it tries hard enough, trigger a recession, does not mean that it can maintain steady growth.”
To top it off, the current Fed faces some especially tricky inflation challenges that it’s not really equipped to solve. There’s not much Powell can personally do to fix the supply chain problems in the semiconductor or auto industries; he can’t make China keep running its factories when a COVID case strikes.
With all of that said, it’s at least possible to picture how the Fed might thread this needle. Powell and his colleagues have a few advantages. First, hiking interest rates could cut down demand for some of the specific big-ticket consumer items that have been driving inflation, particularly cars and trucks. Pushing up mortgage rates might also take some heat off the roaring housing market, in turn slowing sales of appliances and furniture, which have also seen big price spikes. At the same time, with a record number of job openings, it’s at least plausible that the Fed could cool down this sort of consumer spending without hurting hiring much. Finally, if supply chain problems do work themselves out, the Fed may not need to hike as aggressively for inflation to drift back down closer to normal.
Will it be an easy task? No. Success is obviously not guaranteed. But it’s at least within the realm of imagination.
If the Fed fails, there will be two main consequences, one obvious, the other less so. The less obvious one has to do with how central bankers conduct monetary policy. After the Volcker era, Fed officials largely stuck to a policy of trying to halt inflation before it emerged, much like Greenspan did in the 1990s, precisely because they feared that once inflation took off, bottling it back up could require a recession. But that strategy seemed to work poorly after the Great Recession, when the Fed under Janet Yellen and later Powell found itself hiking interest rates to fight phantom inflation that never appeared, likely slowing down job growth in the process. In 2020, Powell’s Fed switched to a new framework in which it vowed not to raise rates before inflation actually started to hit its target. It was a patient approach meant to maximize the number of Americans who could find work.
If Powell can’t slay this current bout of inflation without a recession, though, there’s a strong chance central bankers will return to their old, much more hawkish conventional wisdom, even if it means weaker labor markets in the future. As Oregon’s Duy put it to me: “If this does not have a happy ending, it’s going to turn the established consensus back around.” The Fed’s era of prioritizing full employment over inflation-fighting might end before it ever has a real chance to begin.
And the more obvious consequence? Well, if Americans find themselves living through a lingering plague, and the worst inflation in a generation is followed by a recession, it’s hard not to think that Joe Biden’s presidency will be toast come 2024.