The story of this cycle does not end when recession begins, the story, in fact, begins with the direction Fed policy takes once unemployment starts to rise. Recession of some sort was always inevitable to curb inflation. But with m/m core inflation accelerating since March, up to 9% SAAR in June, and with unemployment at a low 3.6%, soft-landing territory has long been left behind. Raising the funds rate100bp on July 27 to 2.50-2.75% (now expected) still leaves policy rates deep in negative territory. A funds rate of at least 4% is necessary to ensure demand reverses course and begins to create the needed slack to pull inflation back down towards 2%.
How the Fed responds once unemployment rises will greatly determine the course of inflation in the coming years. Leaving real rates high enough long enough for unemployment to stay above 5% for an extended period is the likely prescription to drive inflation back to 2%. The Fed, however, appears all too willing to get back to the AIT playbook once rising unemployment and decelerating inflation come into view and will probably bail as quickly as they can. They believe, like the markets, that inflation’s return to 2% is manifest destiny – or, failing that, perhaps 3% is the right target inflation rate. Markets today, like they were from the mid-60s until Volcker, price in unabashed optimism on inflation decelerating, this time without even a notable disruption to real economic activity, Quickly returning to negative real policy rates was the Fed’s mistake beginning in the mid-60s and that resulted in every successive cycle ending with higher inflation and unemployment rates, until Volcker cracked inflation – aided and abetted by a strong dollar and massive import substitution, an avenue no longer available.
Looking into the June CPI report, several disturbing aspects got the Fed’s attention. One is that core services (without rent of shelter) and core goods (ex food and energy) have been accelerating on a m/m basis since the spring began (Chart 1).
In sum, a recession is unavoidable and seemingly so too is the market’s optimism that every gets back to the way it was pre-Covid rather quickly. There is no recession priced into the forwards, only a sharp reduction in forward inflation expectations. Pay your money and take your chances, but this does not seem like a good bet. Looking beyond the next 18 months, the danger of the Fed bailing too soon on curtailing growth to curb inflation sets up for a return to 1965-79 monetary policy sensitivity that unleashed repeating cycles of rising inflation. Powell is acting more like Arthur Burns than Paul Volcker these days, including the perception that he held back on tightening at the end of last year so he would be renominated. The story to be written for this cycle is what the Fed does once unemployment starts to bite –a cycle the Fed created by its mismanagement of policy last year.