In terms of economic and inflation news, this is a big week. On Tuesday and Wednesday, Jerome Powell and his colleagues at the Federal Reserve will hold a two-day meeting, during which they are expected to raise the federal funds interest rate by another three-quarters of a percentage point. On Thursday, the Commerce Department will release its first estimate of GDP growth in the three months from April to June. Many economists expect a barely positive reading for inflation-adjusted growth, in the range of zero to one percent on an annualized basis. The Atlanta Fed’s GDPNow estimate, which incorporates a range of economic data, projects growth of minus 1.6%, that is, down.
If the GDP growth figure is below zero, it will be the second consecutive negative quarter and lead to more headlines about a recession. Although it is commonly accepted that two quarters of negative growth means a recession, such headlines would be misleading. Powell and his colleagues, like the rest of us, are still struggling to make sense of a crazed pandemic and war-battered economy that is showing conflicting signs of strength and weakness. Employers added 372,000 jobs in June, more than economists had hoped, according to the Labor Department. Retail spending was also stronger than expected. Additionally, the second-quarter GDP figure will likely be negatively affected by unusual, pandemic-related changes in business inventories — things companies have done but haven’t yet sold — which may well be reversed in the future. during the following quarters. But, even taking all of these factors into account, the economy has certainly slowed noticeably this year, and going forward, a recession is a distinct possibility. So why is the Fed still expecting to raise interest rates, a policy designed to have a depressing effect on the economy?
Of course, the answer is inflation, which reached 9.1% in June, the highest rate in more than forty years. Having failed to predict the global price spike that began last year, central bankers around the world are encouraging each other to raise interest rates sharply. Last month, the Fed raised the federal funds interest rate by three-quarters of a percentage point. Earlier this month, the Bank of Canada outperformed its US sibling by raising its benchmark rate by a full point. Last week, the European Central Bank (ECB) introduced a hike of half a point.
These rate hikes came despite some signs that inflation may have peaked. Over the past month, the price of crude oil has fallen back to roughly the same level as it was just before the Russian invasion of Ukraine. The price of gasoline also dropped significantly. In June, the average price across the country for a gallon of regular fuel topped five dollars for the first time, according to AAA. The national average is currently $4.35.
Powell may well welcome these developments this week, but he’s also likely to say it’s too early to change course. Despite the recent decline in oil prices, the Fed Chairman and his foreign counterparts fear inflation is spiraling out of control, something independent central banks like the Fed and the ECB were designed to avoid. “We may be reaching a tipping point, beyond which an inflationary psychology spreads and takes root,” the Basel-based Bank for International Settlements, a sort of central bank for investors, warned last month. central banks. Powell has gotten the message and seems determined to raise interest rates until inflation has come down significantly over an extended period. “The risk is that… you start moving to a higher inflation regime,” he warned a few weeks ago at an ECB forum in Portugal. We will not allow a transition from a low inflation environment to a high inflation environment.”
Even though the Fed Chairman made hawkish comments like these, he also insisted that a recession is not inevitable. In his press conference after last month’s Fed meeting, he said the US economy is “very strong and well positioned to handle tighter monetary policy.” But, if the Fed and other central banks did such a poor job of predicting soaring inflation last year, what reason is there to expect them to get exactly the good results from here? The honest answer is not much.
To his credit, Powell has publicly admitted the scale of the challenge he and his colleagues face. At the forum in Portugal, he pointed out that the economic models they have long relied on to analyze inflation – primarily the Phillips curve, which links high inflation to low unemployment – have collapsed since the start of the coronavirus pandemic. “I think we understand better now how little we understand about inflation,” admitted Powell.
It’s not just inflation that’s proving to be a headache. Minutes from the Fed’s June meeting suggest its officials are struggling to understand how seriously all talk of the recession should be taken. “Participants rated the uncertainty regarding economic growth over the next two years as high,” the minutes read. “A few of them noted that GDP and gross domestic income have recently given mixed signals regarding the pace of economic growth, making it difficult to determine the underlying dynamics of the economy.” It’s Fedspeak for “Right now, we’re perplexed.”
In the face of all this confusion and uncertainty, Powell and his colleagues will likely be relieved that they won’t have another meeting until the second half of September. At this point, what’s happening to inflation and growth should be clearer – or at least that’s what Fed officials are hoping as they face the decision to moderate, or even suspend, their interest rate hikes. Given the experience of the past two and a half years, they should expect the unexpected. ♦