Fed Chai Powell Facing Choice Between Inflation and Recession

FJerome Powell, the Chair of Federal Reserve is confronted with a more grim outlook after another high inflation reading. It appears that he will have to drive the economy into recession in an effort to recover control over prices.

After spending much of last year sounding a bit like the inflation-tolerant, former central bank chief Arthur Burns, Powell has increasingly taken on the mantle of inflation-slayer—and Fed icon—Paul Volcker. It’s a role he’s likely to embrace with relish on Wednesday, when he speaks with reporters after a widely-expected decision by the Fed to raise interest rates by another half percentage point.

But so far at least, he’s shied away from endorsing the tough monetary medicine—and punishingly deep recession—that it took for Volcker to break the back of inflation four decades ago. While Powell has recently acknowledged that getting price pressures under control could require some pain—and maybe even higher unemployment—he’s steered clear of talking about a recession.

That’s perhaps understandable, given how fraught politically that is, especially for President Joe Biden’s Democratic Party ahead of mid-term elections in November.

“The chairman of the Fed doesn’t want to let the ‘r’ word slip out of his mouth in a positive way, that we need a recession,” former US central bank policy maker Alan Blinder said. “But there are a lot of euphemisms and he’ll use them.”

An increasing number of economists—including ex-Fed Vice Chair Blinder—say it may take an economic contraction and higher unemployment to bring inflation down to more tolerable levels, much less back to the Fed’s 2% price target.

“I’ve become more pessimistic about the opportunity of stabilizing inflation at an acceptable level without a recession,” said JPMorgan Chase & Co. chief economist Bruce Kasman. A prolonged period with high inflation and tight labor markets will lead to increased wage demand and higher costs for companies, according to Kasman.

Research published by Bloomberg Economics on June 6th showed that the likelihood of a recession in America this year was one in four, and one next year is three in four. “A downturn in 2022 is unlikely, but recession in 2023 will be tough to avoid,” they wrote.

The investors are paying attention. Stock prices plummeted and bond yields shot up on Friday as investors feared that the Fed might tighten the brakes on policy after reports of consumer price increases at an unprecedented 8.6% in May, compared to the same time last year. Investors placed bets that the Fed would keep hiking at half-points during its September and July meetings. Some economists suggested that an increase of 75 basis points was possible.

The path and ultimate destination of interest rates in coming months will partly depend on how quickly—and how far—policy makers want inflation to cool and how much pain they’re willing to put the economy through to achieve that.

The personal consumption expenditures price index—the Fed’s favored inflation gauge—rose 6.3% in April from a year earlier, more than three times the central bank’s 2% goal. The core price index, which excludes volatile food and energy prices, increased by 4.9%.

Ethan Harris from Bank of America Corp. is head of global economy research. He said the Fed might be open to a compromise, and would accept inflation at 3%. The idea of gradually increasing the target over time, however, was not feasible. This would prevent the U.S. from going into recession.

“Recall that the great inflation fighter Paul Volcker backed off with inflation down to 4%,” Harris said.

Former International Monetary Fund chief economist Olivier Blanchard bemoaned the “screw up” by the Fed and other central bankers in allowing inflation to get out of control.

Blanchard, a former senior fellow at Peterson Institute for International Economics said that the central banks should not tighten their policy when inflation drops below 3%. They should instead set that target price and stop pushing it down lower to avoid a recession.

Blinder claimed that the Fed needs to weigh two different risks.

Inflation will become more entrenched in an economy if it remains elevated for too long. That’s what happened in the 1970s when Burns was Fed chair and it’s the primary reason why Volcker subsequently had to put the economy through such a wringer to get inflation down.

The Princeton University professor said that overly aggressive actions to address persistent price pressures can also pose dangers. The economy could be plunged into severe recession and unemployment will soar.

‘Burnsian Mistake’

Deutsche Bank economist Peter Hooper, who was among the first on Wall Street to forecast a recession, said it would be a “Burnsian mistake” if the Fed backed off from its 2% price target. And that’s a mistake he said that Powell doesn’t want to make.

At least for now, Powell has something that Burns didn’t have: political support for taking action to combat inflation.

Biden, who held a rare meeting with Powell last month, has repeatedly reaffirmed the Fed’s independence to do what it thinks is necessary to tackle surging prices. The president also stated that high inflation is his number one concern. The number one economic problem facing the US is high inflation.

“Inflation is the bane of our existence,” Biden told ABC television late-night host Jimmy Kimmel in a June 8 interview.

–With assistance from Philip Aldrick.

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