MNI: Stagflation Would Force Fed To Hike More-Ex-Officials

Renewed threats to supply chains from war in Europe and Covid lockdowns in China could further fuel inflation and force the Federal Reserve to take interest rates sharply higher, raising the risk of a recession and reversal in job gains, former Fed officials and staffers told MNI.

The FOMC is set to lift rates from rock bottom Wednesday to tame inflation after keeping policy loose through the pandemic to allow the labor market to heal. But economists increasingly fear the U.S. may be headed toward a hard landing in which the Fed battles a 1970s-style stagflation as sky-high oil and food prices and China's zero-Covid policy both accelerate inflation and sap growth.

"The challenge of the soft landing is now even tougher," said Ricardo Reis, an academic consultant to the Richmond Fed and the Bank of England, based at the London School of Economics. "A month ago, the danger was that they’d been too loose. The danger was they needed to speed up. Now with the oil shock there’s really a danger of causing a really bad recession next year if you move too quickly."

UNANCHORED EXPECTATIONS

Prior to the Ukraine war and the energy crisis that followed, Reis expected U.S. inflation to end the year somewhere between 3.5% and 5%. He's widened that band now to 3.5% to 6%.

While war and its associated risks to global investment and consumer confidence are likely to prompt some initial caution among central banks, as MNI has reported, they may see the need for more aggressive action if inflation proves stubborn. (See MNI: Fed Keeping 50 BP Option Open For Later -- Ex-Staffers)

The past six months have been reminiscent of the rapid price inflation of the '70s, Reis said, with an oil shock coming after the Fed had let inflation expectations become unanchored. Others have pointed out that many U.S. recessions have followed oil shocks and a subsequent overreaction on the part of central bankers.

Monetary policy cannot easily address the supply side of an oil price spike. While the Fed would normally focus on core inflation measures, the effect of high gas prices on consumer inflation expectations can't be ignored.

"If inflation threatens to become embedded, I think the committee must try to bring it down even at the risk of a significant slowdown," former Atlanta Fed President Dennis Lockhart said in an interview. "The rationale for that would be that over the longer run, the economy needs stable prices to achieve sustained growth."

TRADE-OFFS

The committee's challenge is to weigh relative degrees of risk and come up with a policy that is optimal, Ellen Meade, a former special adviser to the Fed’s board of governors, told MNI.

"A stagflationary scenario means both their goals are not where they want them to be and they’re moving in opposite directions. So which do they weigh more heavily, the growth component or the inflation component?" she said. "It does seem like they have tools to deal with the growth side of the economy, but only limited tools on inflation, because only some of the inflation we have now is demand-induced."

Fed officials are likely to make the argument that the risk of unemployment worsening materially is not a top concern at the moment. Employment by some measures is very close to pre-Covid numbers. That would allow the FOMC to focus its attention on inflation, the ex-officials said.

To the extent the Fed can manage to ease the gas off the real economy without provoking a recession, "they’re probably willing to tolerate a little more on the inflation side, particularly given that the source of the inflation is supply-driven, and we know that monetary policy is not effective against supply shocks," Meade said.