By Greg Ip 

The Federal Reserve is attempting in the next few years something it has never accomplished before: guide unemployment up without causing a recession. It faces high odds of failure--and little alternative path.

Massive tax cuts, robust federal spending and a synchronized global upswing are expected to push annual growth in economic output to 2.7% this year and 2.5% next--past what Fed officials consider its long-run sustainable rate of 1.8%--according to projections Fed officials released after their meeting Wednesday.

To sustain such growth, the Fed projects employers will have to dig deep into a diminishing supply of workers. That will cause unemployment, already at a 17-year low of 4.1%, to sink to 3.6% by the fourth quarter of 2019, a level last seen in the 1960s. That's well below the "natural rate" of 4.5%, which is the rate Fed officials and many economists think the economy can sustain without eventually producing inflation.

For now that's to be welcomed, as inflation has for several years now been below the Fed's 2% target. An overheating labor market will help push it back to 2%, or even slightly above that level, according to Fed projections.

But it faces a problem: In theory, unemployment will eventually have to go back to 4.5%, or inflation will head even higher. Yet since records begin in 1948, unemployment has never risen by 0.9 points, except in a recession.

Of course, this is not the Fed's plan. Chairman Jerome Powell intends to gradually raise interest rates so that growth and unemployment return to their long-run sustainable levels and inflation reaches the Fed's target.

At a press conference Wednesday, Mr. Powell downplayed the significance of the Fed's longer-term projections, saying they reflect a range of disparate views over a time horizon fraught with uncertainty.

His comments suggest he's more open than some to the idea that unemployment can stay lower than in the past. And he noted that the link between unemployment and inflation--dubbed the Phillips curve--has weakened.

"We will know the labor market is getting tight when we do see a more meaningful upward move in wages," he said. So far he's not seeing much of it.

Yet even allowing for the uncertainty around the future and the natural unemployment rate, the Fed faces long odds. Even the most optimistic Fed official thinks the natural rate of unemployment is still 4.2%. It's true that in the past the Fed has achieved "soft landings"--a rise in rates that slows the economy without a recession. But this has never required actually raising unemployment.

It may seem absurd that the Fed could trigger a recession by raising its short-term rate target, now between 1.5% and 1.75%, to just above 3%. But recessions aren't caused simply by higher interest rates, but by a complex series of events: Higher rates cause asset prices to fall, credit to tighten, and businesses and households to become more risk-averse.

Both the 2001 and 2007-2009 recessions were driven more by collapsing asset prices than by higher interest rates. By some measures--such as household net worth as a share of after-tax income--asset prices are even higher now. Fear is more powerful than greed, so just as markets fall faster than they rise, unemployment rises faster than it falls.

This time, there's an added hurdle. Krishna Guha, an analyst at Evercore ISI, noted that the growth impulse from federal tax cuts and spending increases in 2018 will end around 2020, just as the Fed has pushed rates over 3% to keep inflation from overshooting. At the same time, global growth is also likely to slow as foreign central banks withdraw their own stimulus.

Congress and President Donald Trump have injected fiscal stimulus into an economy already close to full employment. The Fed can't do much about it in the near-term even by tweaking its rate path, Mr. Guha said.

He argued that this elevates the probability of recession in 2020 or 2021 --unless productivity growth suddenly accelerates, giving the economy more room to run without inflation.

By the way, 2020 is when Mr. Trump should be campaigning for reelection--setting up an interesting year in Washington and on Wall Street.

Write to Greg Ip at greg.ip@wsj.com

 

(END) Dow Jones Newswires

March 22, 2018 05:44 ET (09:44 GMT)

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