Fed Rush to Catch Up on Inflation Raises U.S. Recession Risks

(Bloomberg) -- The Federal Reserve faces a growing risk of making a policy mistake, tipping the economy into a recession, as it confronts decades-high inflation that’s proving more persistent and broad-based than policy makers expected.

After holding interest rates near zero since the start of the pandemic, Fed Chair Jerome Powell and his colleagues are poised to embark on a credit-tightening campaign next month, with some economists forecasting an outsized half percentage-point increase to start the cycle.

The danger is that, with price gains far above its 2% target, the Fed will be pressured into overdoing it -- pushing the economy into a downturn by rapidly raising borrowing costs for consumers and companies, and cratering financial markets that have grown used to its ultra-expansionary monetary policy.

At the same time, fiscal policy also will be acting as a damper on growth. As prices for everything from gasoline to rent have surged, support has waned for President Joe Biden’s push to reshape the economy by strengthening social investments, with his poll numbers sliding.

Economists from both sides of the political spectrum see rising risks of a recession. Former Fed Governor Lawrence Lindsey, who served in the White House under Republican President George W. Bush, puts the odds of a downturn by the end of next year at above 50% -- triggered by a meltdown on Wall Street.

“When you’re wrong in one direction and you’re painfully wrong, you’re going to have to end up with too much heavy lifting to go in the other direction,” Lindsey, who now heads his own consulting firm, said of what he sees as the Fed’s delay in recognizing and responding to the budding inflation problem.

Ex-Treasury Secretary and Democrat Lawrence Summers agreed. “The Fed has allowed itself to get far further behind the curve” in battling inflation, Summers, who is a paid Bloomberg TV contributor, said. “The risk a recession will start in the next 30 months is certainly 50%.”

Six Hikes

Traders in the money markets are wagering on roughly six quarter percentage-point increases by the Fed this year. Layered on top of those hikes will be a yet-to-be-specified reduction in the Fed’s balance sheet, which now stands at $8.9 trillion. That will take liquidity out of the financial system -- potentially unsettling bond and stock markets.

“I don’t think we’ve priced in balance-sheet tightening really in the equity market at all,” Bloomberg Intelligence chief equity market strategist Gina Martin Adams said. “We’ve just barely started talking about it.”

For his part, Powell is betting that a judicious tightening of monetary policy, combined with an easing of supply-chain bottlenecks and the winding down of the federal government’s pandemic-relief programs, will help rein in inflation without upending the economic expansion.

But he’s acknowledged that he’s been surprised by the potency of the price pressures, and he’s vowed the Fed will do what it takes to prevent elevated inflation from becoming embedded in the economy.

What’s caught the Fed on the hop is not just how much inflation has accelerated: Consumer prices soared at a 7.5% year-on-year rate in January, the fastest in four decades.

It’s also been the breadth of the price increases. About 90% of the components that make up the consumer price index are running above 2% -- the Fed’s official inflation target, according to calculations by Bloomberg Economics.

That’s “a cause for somewhat greater concern,” said former Fed official David Wilcox, who is now director of U.S. economic research at Bloomberg Economics. “That gives rise for more of an inflationary psychology to become entrenched.”

In a sign of the widening inflationary pressures, home and car insurer Allstate Corp. has boosted rates by an average 7.1% across 25 states, and is planning further increases.

“We are continuing to go at a very fast pace across other states,” senior Allstate executive Glenn Shapiro told Wall Street analysts in a Feb. 3 conference call. “And even in some cases, the same states again with rate increases, as we get new data and new trends.”

Powell has also flagged stepped-up wage increases as something to watch.

“We are attentive to the risks that persistent real wage growth in excess of productivity could put upward pressure on inflation.” he told reporters on Jan. 26. 

The tight labor market -- at 4%, the unemployment rate is below the level that prevailed for much of the previous expansion -- has led employers to bid up wages in an attempt to fill millions of job openings and to retain workers. Last year, compensation costs surged by the most in two decades.

“As you go into this year, we are expecting that there is going to continue to be pressure on wages,” McDonald’s Corp. Chief Executive Officer Chris Kempczinski said in a Jan. 27 earnings call. “Certainly, as we’re thinking about our pricing, we’re thinking about how do we put pricing that can anticipate that.” 

The trouble for Powell and the Fed is that the central bank will be tightening policy to slow the economy and reduce inflation just as the expansion will be downshifting on its own, after growth last year clocked in at the fastest since 1984. 

“The Fed is tightening into a slowdown,” Sarah House, senior economist at Wells Fargo Securities, said. “That does point to some risks around if they go too fast.” 

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