Analysis: Recession risks rise as Fed faces daunting task

The chances of a recession have gone up. Drastically.

Wall Street is betting higher on it. Policymakers are clinching their teeth. And jittery Americans are beginning to put off big-ticket purchases.

The latest inflation reading was supposed to offer hope that the U.S. economy had weathered the worst of the storm. But there was nothing reassuring in Wednesday’s report. In fact, inflation actually got much worse in June across the economy, making it even harder—and more unlikely—that the Federal Reserve can bring down prices without triggering a recession.

Price growth surged to a new four-decade high, with inflation up to 9.1% for the 12 months ending in June, according Labor Department data. That unexpectedly high reading, combined with a stronger-than-expected June jobs report, means the central bank is likely to take even more aggressive action to cool the economy.

“The odds of a recession have definitely gone up,” said Rodney Ramcharan, an economics professor at the University of Southern California and former senior economist at the Federal Reserve Board. “The central bank is a powerful institution, but there’s no way it can carefully calibrate these interest rate increases to avoid a recession.”

During the pandemic, the Fed had allowed borrowing costs to go down to close to zero, to help the economy grow during a tense time when millions of people lost their jobs all at once. Now the economy looks like it’s bubbling over, with prices showing no signs of easing. The Fed has already raised interest rates three times this year—most recently in June by three-quarters of a percentage point—to try to control inflation. But stubborn price increases mean the central bank has much more work to do.

Economists now expect the Fed to raise interest rates by another 0.75 percentage point later this month, and there is new talk of a full one percentage point hike, which would be the largest one-time increase since the central bank began announcing rate hikes in the early 1990s. The Fed is trying to raise the cost of borrowing for businesses and households to slow spending. Slowing spending is supposed to slow inflation.

The Fed faces a tough decision after that. If inflation continues to rise, central bankers would have to decide whether to keep raising rates and potentially halt any economic growth in the final months of 2022. In the past, the Fed has only managed to avoid a recession with these kinds of rate hikes a handful of times.

How far the Fed goes down this path will determine the likelihood of a recession.

“The Fed faces a daunting policy challenge,” said Gary Stern, who was president of the Federal Reserve Bank of Minneapolis from 1985 to 2009. “Inflation has turned out to not only be higher but more sustained than they expected, and there’s no convincing sign that it’s abating.”

Essentials like fuel, food and housing have all gotten more expensive in the past year. Gas prices have nearly doubled—though they have inched down from mid-June peaks—and the cost of staples like rice, milk, butter and baby food have all risen by 12% to 16%.

Housing costs, meanwhile, are up nearly 6% and are likely to become an even bigger driver of inflation in coming months.

“Up until now, inflation reports have been disappointing but this latest one was just painful,” said Ellen Gaske, an economist at PGIM Fixed Income and former senior economist at the New York Fed. “Households are going to feel this. Their wages are not keeping pace with this kind of widespread inflation.”

On Wednesday, President Joe Biden called inflation “our most pressing economic challenge” and talked about the importance of bringing down price increases. He has also said a recession is “not inevitable.”

The White House has misjudged the persistence of inflation for more than a year. And now, the global economy is looking a lot rockier than it did six months ago. The World Bank warned in June that the global economy could face several years of weak growth. And recession fears are sweeping through Europe.

Canada’s central bank on Wednesday raised interest rates by one percentage point in hopes of tamping down on the country’s 7.7% increase in prices over the past year.

Wall Street is already pricing in a similar rate-hike in the United States. Financial markets recoiled following the release of the new inflation data, as investors grappled with figures suggesting that peak inflation has yet to arrive, which could prompt the Federal Reserve to push the brakes on the economy even harder.

All three major stock indexes slumped on Wednesday. Market observers will also be closely watching corporate earnings this week. The financial snapshots offer another signal as to how businesses are coping with the high-inflation environment and how the actions of the Fed are influencing market conditions. Investors will also get a glimpse of business projections looking ahead to the second half of the year, providing more guidance on the direction of the economy.

Although inflation hasn’t budged—and has in fact gotten worse—some economists point to promising signs of cooling in other parts of the economy signaling that a recession isn’t imminent or inevitable. Job growth, though still exceptionally strong, is slowing. Consumers are beginning to think twice about spending on goods and some services. And there are signs that higher mortgage rates are leading to a slowdown in home sales. All of these forces work to cool down the economy and could help the Fed do its job without getting too far into the restrictive area.

“The totality of the data is more reassuring: These are all parts of the economy that need to slow to bring down inflation,” said Jason Furman, an economist at Harvard University and top economic adviser in the Obama White House. “I don’t think it’s time to start panicking yet. You should be nervous and wary, yes, but not panicking.”

In Boise, Idaho, the mood among prospective home buyers began souring early this year, shortly after the Fed began talking about raising interest rates. Demand for new homes has continued to drop as mortgage rates tick up, according to Colby Henry, a loan officer at Benchmark Mortgage. Rates for a 30-year mortgage have risen from 2.9% to 5.3% in the last year, according to Freddie Mac.

“It used to be that we’d be talking to 20 people a day and they were all making offers, and now we’re talking to four or five,” Henry said. “There’s a lot of confusion. A number of people we’d been working with were like, ‘No, we’re going to wait and see what happens.'”

The likeliest scenario, economists say, is several months of even higher interest rates. The federal funds rate—the overnight lending rate controlled by the central bank—is currently 1.5% to 1.75%, although it may have to go as high as 6% before it can make a dent in inflation, said Jeffrey Lacker, an economics professor at Virginia Commonwealth University and former president of the Richmond Fed.

“This is another terrible inflation report and just the latest sign that the Fed still has a long way to go,” he said. “There’s no way to rein in inflation without a recession, and it won’t surprise me if we enter one this year.”

Fed Chair Jerome Powell has maintained that the central bank will be able to engineer a “soft landing”—slowing the economy enough to muffle inflation without causing a full-blown downturn with massive job losses—although he has acknowledged growing concerns that it will be difficult to pull off.

“Do I still think that we can do that? I do,” Powell said in a news conference earlier this month. “Events of the last few months have raised the degree of difficulty, created great challenges . . . there’s a much bigger chance now that it’ll depend on factors that we don’t control.”

The inflation data released Wednesday reinforced how challenging Powell’s task has become.

“I’m not sure we’ve ever had a soft landing—people can talk about it and they can hope for it, but in my opinion it’s not going to happen,” said Stern, the former Minneapolis Fed president. “I expect we will have a recession—it’s likely to be relatively brief and relatively mild—but I personally doubt a significant reduction in inflation is achievable without it.”