The Fed: ‘This is going to hurt’

There are many things you don’t want to hear from your doctors: “What an interesting case!” means they are baffled. “You know, I haven’t seen these symptoms since med school” means they’ll be dusting off their textbooks. And “This may hurt” means this is definitely going to hurt.

Note the echoes in recent messaging from the U.S. Federal Reserve. When COVID-19 first struck, officials stressed how we were entering unprecedented policy territory given the massive shock and systemic response. Then they talked about distant parallels to the inflation of the early 1980s. Now, they say all the right things about growth and employment but stress these won’t be sustainable unless price pressures are tamed first.

The U.S. economy should still avoid a recession next year, since Americans socked away ample savings during the pandemic and companies tapped markets awash with cheap money. But the slowdown will come with costs, in a struggle that may drag well beyond next year.

Fed Chair Jerome Powell used the word “pain” three times in a short answer to a journalist recently, emphasizing that “ultimately, the most painful thing would be if we were to fail to deal with it and inflation were to get entrenched in the economy at high levels.” Just last week, Vice Chair Lael Brainard conceded the Fed still has “a lot of work to do to get inflation down to our 2 percent target.”

So far, measures of inflation expectations confirm that both consumers and investors have confidence the Fed can drive inflation lower. The first half of the journey, however, will be much easier than the second half.

Barring yet another unexpected shock, cooling consumer demand and some normalization of supply chains should provide enough help to lower Consumer Price Inflation from current readings above 8 percent to, say, 5 percent by early next year. But reaching the Fed’s official 2 percent target — and staying there — will require credit markets, job openings and consumer spending to return to more normal levels. Or more.

Credit may be the easiest of the three. A few hikes combined with promises of more already have led to an overall tightening of financial conditions. Bond issuance has dried up this year, with companies comfortably afloat on the cheaper debt they took on last year. The Fed started shrinking its balance sheet last week, likely further restricting liquidity over the next several months.

Job market indicators have cooled slightly, too, although unemployment remains near historical lows, wages are still rising well above pre-pandemic rates, and workers continue to quit their current positions on a comfortable assumption they will find something better. Tesla’s announced job cuts may be a harbinger of things to come, although strong May payrolls numbers confirm the Fed has more work to do.

Most difficult may be taming the animal spirits of American consumers, some of whom consider shopping a patriotic obligation. As measured in confidence surveys, spirits already have fallen as gas and grocery bills soar, but Americans are still spending 18 percent more than they did before the pandemic. The Fed won’t want to consider easing policy until it’s fairly certain that this holiday shopping season will be worse than last year’s.

If these are the hard parts of driving inflation toward 2 percent, there remains plenty of uncertainty in all the areas of the global economy beyond the Fed’s control. The sharp fall in Russian exports of energy, wheat and other commodities will take several years to work through world markets, keeping prices higher for longer. Shanghai’s reopening sounds promising, but China’s continuing battle with COVID threatens further supply shortages. Finally, with U.S. homes in structurally short supply, even higher mortgage rates may not substantially reduce housing costs.

If this sounds excessively gloomy, risks of actual negative growth rates next year still look low. Even if savings and cash levels dwindle, there is plenty of room for households and companies to borrow. If inflation drops below 5 percent, as expected, there also will be greater confidence around a tighter range of borrowing costs. Moreover, unemployment that edges up a couple of percentage points would put it comfortably back at 2016 levels, when growth ended the year respectably above 2 percent.

But even if we avoid the worst, brace for a bumpy path with confusing data and markets alternately worried about spiking prices and sagging demand. And don’t think that just because headline inflation numbers move lower this year the battle next year won’t be even harder and more protracted.

Indeed, if the treatment doesn’t hurt, it’s not going to work.

Christopher Smart is managing director, chief global strategist and head of the Barings Investment Institute. Under President Obama, he spent four years as deputy assistant secretary of the Treasury and two years as special assistant to the president for international economics, trade and investment. Follow him on Twitter @csmart.