Wall Street can’t shake a nightmare about the US economy.
The nightmare isn’t that the country is slipping into recession because of the Federal Reserve’s attempts to fight inflation — it’s much worse.
The latest night terror came on Tuesday, when the Bureau of Labor Statistics said the consumer price index rose 0.1% in July-August and 8.3% year-on-year — above analysts’ predictions of a monthly decline 0.1% and 8.1%. annual growth.
Things looked ugly under the hood, too: while gasoline prices fell, grocery costs rose 13.5% last year — the biggest increase since 1979 — and health insurance costs rose 24.3%, the biggest increase in the world history of the United States.
This disappointing report means Wall Street’s nightmare scenario for the economy is still in play. In this scenario, there is no hard or soft landing for the economy; we just get stuck. Inflation is declining somewhat from its blisteringly hot level but remains persistently higher. The Federal Reserve — for reasons ranging from a fragile labor market to government debt — cannot aggressively shake higher prices out of the system. And Americans both have uncomfortably high interest rates on things like mortgages and credit cards and higher prices that continue to eat up wages and destabilize prices.
Basically, the economy sucks.
Soft, hard and neutral
The Fed’s current goal is to return the economy to a “neutral” state where growth is stable, jobs are holding up, and inflation is high enough to boost growth but not high enough for us have price instability. In a healthy US economy, the Fed’s inflation target is 2% yoy.
Since the 2008 financial crisis, the Fed’s biggest problem has been inflation too low. So it kept interest rates at 0% to boost financial activity and growth. Then the COVID-19 pandemic hit, supply and demand were thrown out of balance, and finally inflation rose as the economy reopened.
When inflation begins to creep in, central banks like the Fed raise interest rates to make borrowing more expensive. This slows the flow of money through the economy and theoretically slows price growth. But in this case prices didn’t rise – they shot up and the Fed faltered.
Wall Street constantly berates the Fed for acting too late to keep up with inflation – for not raising rates fast enough. But I’m not here to delve into hypotheses about past politics. In the world of financial markets, it’s an instant go from a polite country club chat to something like an argument in Elon Musk’s Twitter mentions.
But we can all accept that the Fed now has a serious problem. Chairman Jerome Powell and his gang have been raising interest rates fairly quickly, but the Fed’s main interest rate is still only 2.5%. That’s not enough to take us out of 8% inflation, let alone bring us back to the Fed’s 2% target. That’s why the Fed says rates will keep going up.
The difference between a hard landing and a soft landing for the economy is in how this gap is closed. In a soft-landing scenario, supply catches up with demand, prices cool, and inflation numbers fall to match interest rates without the Fed having to inflict too much pain on the jobs market or push us into a recession. In a hard landing scenario, the Fed will hike rates to accommodate inflation, which in turn slows the economy, sends unemployment rates skyrocketing, and plunges us into recession.
But there is a third option where the pain we experience lessens but never entirely goes away.
A long way to go
This is where Wall Street’s nightmare scenario comes into play. It’s not a hard or soft landing. It’s not a landing at all.
Earlier in the year, the price increase came mainly from categories influenced by external influences, such as gasoline prices and used cars, which were boosted by the Russian invasion of Ukraine and the pandemic respectively. But as the months go by, that price pressure eases. Inflation is starting to come from ‘stickier’ categories: housing rents, health care and services. This seriously increases the likelihood that inflation, rather than going away on its own, will be with us for a long, long time.
The worst case is an economy where interest rates and inflation never meet. It’s a limbo of stubbornly high inflation and higher interest rates. The Fed continues to raise interest rates, but never in a way that truly tames inflation. Price growth is around 4% or 5%, well above the Fed’s target. Businesses face rapidly rising input and labor costs, higher borrowing costs, and great uncertainty about economic growth. It’s also terrible for employment and American households. Jason Furman, who was the White House economist during the Obama administration, said after the CPI report came out that while this isn’t its most plausible case, this nightmare scenario of over 4% inflation and an unemployment rate over 6% is still on the table.
David Einhorn, founder of the hedge fund Greenlight Capital, also spoke about this catastrophic scenario at the Sohn Investment Conference in June. He said that with inflation at 8%, the Fed would need to hike rates up to 7% to achieve neutrality.
“The idea that tightening by a percent or two from here will beat inflation is hard to believe,” he said. Einhorn argued that the Fed needed to hike more drastically — to give the economy a massive boost like Paul Volcker did as chairman in the 1980s. But Einhorn added a worrying wrinkle to this scenario: that the Fed would be held up by the high interest rates inflicted on the US Treasury.
“Powell faces a problem that Volcker didn’t have,” Einhorn said. “We have $24 trillion in debt held by the public, which has increased more than sixfold over the past 20 years. Approximately $7 trillion needs to be rolled over the next year. Every 1% increase in interest rates adds $70 billion to the deficit. So raising interest rates to 4% would add $280 billion, 8% would be $560 billion, and a full Volcker — 19% — would be $1.3 trillion. And that’s just the first year.”
In the face of all this, the Fed must blink and stop raising rates, leaving us with persistently high inflation and economy-wrecking interest rates. And Einhorn isn’t the only one who thinks the Fed’s policy is being constrained in this way. In August, Francesco Bianchi of Johns Hopkins University and Leonardo Melosi of the Chicago Fed published a paper arguing that lack of restraint on household spending is also psychologically driving inflation. With no one in Washington stopping spending, the market doesn’t believe economic conditions are really going to tighten. If the market is to believe we are serious about inflation, we need to tighten our fiscal policy, they argue.
If Einhorn, Bianchi, and Melosi are right, we could be in an economic limbo of stubbornly high inflation and higher interest rates for a while.
None of these scenarios – good, bad, or ugly – are certain. The Fed has only been raising rates for a few months and we don’t have enough inflation data to know if their policies alone will be enough to turn us back to neutral. Analysts at JPMorgan believe a soft landing is still within reach. The US is still creating jobs at a steady pace and the consumer is still going strong. China’s economic slowdown is pushing down commodity prices. We can hope that Ukrainians will continue to push Russian forces out of their territory, which would also help stabilize food prices. All is not lost.
Einhorn acknowledged that his theory could be wrong, but the Fed can be wrong, too. It’s possible that the Fed’s failure to raise rates earlier in the pandemic will result in it raising rates drastically next year and pushing our economy into recession. Or maybe everything will sort itself out without too much economic pain.
But there’s also the horrible, miserable third way, where we can’t beat inflation at all. We should hope to avoid it at all costs.
Linette Lopez is a senior correspondent at Insider.
