Understanding Why The Federal Reserve Has To Trade Economic Downturn For Lower Inflation

Understanding Why The Federal Reserve Has To Trade Economic Downturn For Lower Inflation

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To get inflation under control, the Federal Reserve may have to blow up the economy with a fourth consecutive interest rate hike expected on Dec. 2 and a possible fifth one before the end of 2022, exacerbating fears of a recession.

It’s uncertain whether the massive rate increases and tightening Fed policy will produce a mild downturn or a severe one because the Fed is in unchartered territory, CNN reported. The last three Fed chairs never had to raise rates so high and so often.

The housing market is already starting to show signs of strain with skyrocketing mortgage rates moving in tandem with the benchmark 10-year Treasury, and bond yields spiking.

Inflation is no longer a transitory or cyclical problem but has become a structural one, according to Zoltan Pozsar, global head of short-term interest-rate strategy at Credit Suisse in New York.

This is due in part to supply disruptions that arose from reduced mobility caused by the covid-19 pandemic and changes in Russia and China, along with tighter labor markets due to immigration restrictions, Pozsar wrote in a client note.

The rebound in gross domestic product (GDP) in the third quarter after two straight quarters of economic contraction may help allay recession fears. It could also empower the Fed to continue raising interest rates aggressively, even if it causes a recession.

The unemployment rate, which fell to 3.5 percent in September, is expected to rise to 3.6 percent in October — still almost a 50-year low. And wages have grown faster than average, although not as fast as inflation.

“As long as the jobs market remains healthy the Fed is probably going to continue to focus solely on its price stability mandate and ignore all that stuff about maximum employment,” Paul R. La Monica reported for CNN.

The Fed is not being too aggressive and the U.S. is in for a hard landing regardless of what the Fed does, said Economist Nouriel “Dr. Doom” Roubini in a CNN Business interview. Roubini predicted in 2019 that the next recession will be immune to monetary solutions.

“(If) The Fed doesn’t fight inflation, we’re going to have runaway inflation. If they fight it, we’ll have an economic crash and a financial crash,” Roubini said.

“This hard landing is not going to be short and shallow,” Roubini predicted. “Before, they were hoping for a soft landing, then they said it’s going to be short and shallow, but with these amounts of debt in the system — zombie, household, corporate, financial institutions, governments, countries — the increased interest rates are going to create debt prices and financial stress that’s going to make the recession worse, so damned if you do and damned if you don’t.”

Roubini said he does not expect hyperinflation.

“I don’t even expect double-digit inflation, but I think that it’s mission impossible to go back to 2 percent (the Fed’s annual inflation goal),” Roubini said. “The new normal is going to be something above 5 percent and … below double digits. Sounds like a little but the anchoring and inflation expectations is going to cause long-term interest rates to rise very sharply.”