Will the Fed Cause a Recession? Why Inflation Is Out of Powell’s Control.

Text size

About the Author: J.W. Mason is Professor of Economics at John Jay College, City University of New York and a Fellow of the Roosevelt Institute.

For attentive listeners, there was something tragic about Federal Reserve Chairman Jerome Powell’s press conference on Wednesday. It was the sound of a man who has been given a job he knows is impossible, but feels compelled to continue regardless.

Perhaps the most telling moment came when a sharp-eyed Matthew Boesler of Bloomberg noted the disappearance of a line found in earlier statements released by the Federal Open Market Committee. Previously, they had said that a return to 2% inflation was consistent with still strong labor markets, but not anymore. Did that mean the Fed was now predicting a recession?

Well, answered Powell, it’s always strength be possible to reduce inflation without a recession. But, he added, “these routes have become much more difficult due to factors beyond our control… [like] the fallout from the war in Ukraine, which has led to soaring prices for energy, food, fertilizers and industrial chemicals, as well as supply chains more broadly… This sentence says on the face of it that only monetary policy can do that. And it just didn’t seem appropriate.

This was the key moment. The Fed Chairman acknowledged that the current inflation is mainly due to factors that have nothing to do with credit conditions in the United States.

Indeed, we’re looking at a job that requires a sewing machine, or maybe a fire extinguisher, while Powell only has a hammer. But as the rest of the press conference made clear, he plans to keep rocking it.

Let’s take a step back. Today’s macroeconomic orthodoxy places economic management in the hands of the central bank, which relies primarily on a single instrument, the overnight interbank interest rate. This device is based on a certain model of the economy. In this model, supply—the productive capacity of a country’s workforce and businesses—grows at a steady rate. Expenditures, on the other hand, can be ahead or behind, depending mainly on the evolution of the financial system. Asset bubbles can increase desired spending beyond what the economy is capable of producing, as businesses profit from cheap financing and households from their paper wealth. Bank failures can cut credit, pushing spending below potential.

If these hypotheses are true, it makes sense that the institution that sits at the top of the financial system is also the one that manages macroeconomic imbalances such as inflation or unemployment.

But the assumptions may not hold. Macroeconomic disruptions can come from the supply side rather than the demand side. Demand may fluctuate for reasons unrelated to funding. Supply and demand may not be independent of each other. Depressed demand can discourage capacity-building investments, while high demand can encourage them.

In these cases, the Fed’s power over the financial system may not be enough to stabilize the economy. Efforts to compensate for supply disruptions by adjusting the flow of credit elsewhere may not solve the underlying problems, or even make them worse.

Until recently, the Fed seemed to think that current inflation was the kind of problem it was supposed to solve. Statements earlier this year described rising prices as a symptom of excess demand and a labor market “tight at an unhealthy level”. Higher interest rates would moderate labor demand, with slower wage growth feeding into lower prices. As recently as May, the stated aim was to “lower wages”.

But now Powell has more or less admitted he was aiming in the wrong direction. In another highlight from the press conference, he said, “Wages aren’t primarily responsible for the inflation we’re seeing.” This judgment is consistent with what other economists have found. But this raises the following question: if wages are not the engine of inflation, why are we fighting inflation with tools that mainly act on wages?

It turns out that today’s inflation has nothing to do with an overheated economy. It is mainly due to global factors. Among rich countries, the United States stands out for the scale of its stimulus spending over the past two years. But its inflation performance is near the middle of the pack. As Powell himself noted, “many countries are looking at 10% inflation, and that’s largely driven by commodity prices.”

Energy prices in particular, which appeared to have stabilized at the end of 2021, have risen since Russia invaded Ukraine. This contributes, perhaps more than anything else, to the feeling of panic around inflation. And yet, as the president says, “Gasoline prices are… not something we can do anything about.”

What the Fed can do is discourage new housing construction (housing starts fell 14% in May), making housing more expensive, not cheaper, in the long run. What the Fed can do is transfer bargaining power in the labor market from workers to employers, causing wages to fall even further relative to the cost of living. What the Fed can do, if it pushes hard enough, is tip the economy into recession.

As the press conference made clear, Powell knows full well that none of this will address the real sources of the price hike. But it’s his job, and he intends to continue to do so.

Guest comments like this are written by writers outside of Barron’s and MarketWatch newsroom. They reflect the views and opinions of the authors. Submit comment proposals and other comments to ideas@barrons.com.