Fed's Mission Improbable: Lift Unemployment--but Avoid Recession
March 22 2018 - 5:59AM
Dow Jones News
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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