Can Federal Reserve save economy?

As president of the Federal Reserve Bank of New York and vice chair of the policy-setting Federal Open Market Committee, John Williams is perhaps the second-most influential US central banker behind Fed Chair Jerome Powell. There’s no doubt he is well-rooted in economic fundamentals. And yet, he expects the economy to perform nothing short of a miracle.

In a speech Williams gave to a virtual event hosted by the Economic Club of New York earlier this week, he predicted the Fed would need to continue raising interest rates into next year and possibly hold them at that higher level into 2024 to reign in the highest inflation in four decades.

Williams added that the unemployment rate would likely drift up to a more sustainable range of 4.5% to 5% next year from the very tight current level of 3.7%, resulting in a “modestly” expanding economy.

The problem with that last statement is that it suggests the economy would violate the Sahm Rule. The rule is a bit technical, but in essence it says that if the unemployment rate rises from its three-month average by more than half a percentage point within a year, then the economy is entering a recession -- if it isn’t in one already.

And yet, Williams’s comments imply a recession would be avoided even with his forecast of a big increase in the unemployment rate.

Can unemployment rate be steady for a long time?

At first, businesses and consumers are generally reluctant to make changes in their spending and employment practices in response to what might turn out to be a temporary loss in income or demand.

So, consumer spending holds up, which allows businesses to keep employees on the payroll, which in turn provides consumers with a steadier income, and the cycle repeats.

However, there is only so much stress this two-sided reluctance can endure. Once the breaking point is reached, it kicks off a self-reinforcing cascade in the opposite direction. Consumers cut back drastically, forcing businesses to make major layoffs, which in turn reduces incomes for consumers.

The Current US Economic Situation

In light of the current situation, consumer spending has held up well, but that’s probably due to the unprecedented buildup of $4 trillion or so in excess savings during the pandemic -- money that has helped households weather the shock of faster inflation and higher borrowing costs.

Likewise, the job market is unusually resilient, but that’s coming after a period when businesses struggled to attract staffing. So, it stands to reason that employers are reluctant to cut staff in case the economy avoids a recession and picks up again.

The implication is that consumers and businesses might be able to ride out the current series of large economic shocks, just as they rode out more modest shocks during normal times.

Yet, the Fed is raising rates precisely because it wants consumers to make major downward adjustments to their budgets.

Can Fed save economy?

Williams’s prediction that the unemployment rate will rise to a range of 4.5% to 5% suggests that businesses will respond to such a structural hit to demand by shrinking their workforces. In other words, the first step in the self-reinforcing cascade that leads to recession is a necessary consequence of the Fed achieving its goals.

So not only is a recession unavoidable, but what looks like resilience in both consumer spending and the labor market is actually a reflection of large and sweeping adjustments.

That doesn’t mean the economy is doomed, as the Fed and Williams could be wrong about the source of inflation, but it does mean that those hoping the Fed can take the boil of the labor market without upending the broader economy should give up the ghost.

Source: Bloomberg