Where Does The Fed Go From Here? For Jay Powell, The Only Focus Is Inflation

You are carrying a baseball bat. But you know that getting into a fight with an unruly 300-pound beast is going to wreck the house. You try nudging him out the door without creating a lot of collateral damage, but that doesn’t work. So now it’s clear that some furniture is going to get broken.

This is the situation Federal Reserve Chair Jerome Powell finds himself in today. The gorilla, of course, is the US inflation rate, which hit a punishing 9.1% in June, pumped up by higher energy costs and food. Even though the economy is slowing, the gorilla just isn’t getting off the couch, and now it might be time to start smashing a few lamps to get across the idea that your threat is real.

When they started raising rates in March, Powell and his colleagues held out the hope that they could engineer a soft landing for the economy. Workers would come back in droves to the labor market, reducing wage pressure. Almost magically, knotted supply chains would unravel, and microchips, bicycles, and everything else would flood back into the US as the coronavirus subsided abroad. Inflation was supposed to cool, with no cost to jobs.

Vladimir Putin shattered this hopeful scenario with Russia’s invasion of Ukraine, which exacerbated inflation by raising food and energy prices even more. But the Fed’s analysis, which seemed to underestimate inflation’s spread beyond goods into services, is also to blame—and now the only option is a steady dose of interest-rate medicine to make things right. “They were trying to rule out a recession, and that doesn’t make any sense” if you’re trying to convince a stubborn adversary such as inflation that you mean business, says Jason Thomas, head of global research at the Carlyle Group in Washington. “The paradox is that the only way to achieve a soft landing is to stop trying to convince people that this is reasonable” and keep the threat of something worse, such as a recession, always present, he says.

That’s just what Powell may be doing. At his July 27 press conference, he said the economy was likely to slow and the labor market soften as the Fed continued to raise interest rates. He’s gone from talking about a soft landing to a softish one, and the next step may be to forecast a sharper rise in unemployment.

Powell’s colleague Mary Daly, the president of the Federal Reserve Bank of San Francisco, said on Aug. 2 that the rate campaign is “nowhere near” done with the policy rate, now in a range of 2.25% to 2.5%. Markets are pricing in close to a full percentage-point increase in the benchmark lending rate by the end of the year, which would make it the most aggressive tightening drive since former Chair Paul Volcker began his assault on inflation in late 1979.

This isn’t the world Powell, a former private equity man from Washington, was expecting. Going into the pandemic, he was finishing up a new strategy aimed at managing inflation that was running too low. (How quaint!) As for employment, the other element of the Fed’s mandate, Fed officials defined it as a “broad-based and inclusive goal” and said they would no longer prejudge when the economy was at full employment. The pandemic upended that project, and nobody knows what will remain after this latest bout of inflation is vanquished. Central bankers are acutely aware that geopolitical alliances have shifted and the well-lubricated trading regime that helped lower inflation globally is broken. “I don’t think we are going to go back to that environment of low inflation,” European Central Bank President Christine Lagarde told the ECB’s annual forum in Sintra, Portugal, in June.

In the US, labor force participation by people age 25 to 54 has averaged 88.1% since the start of 2020, a percentage point below the average for the two years ended 2019. If immigration doesn’t pick up, the US will likely face tight labor markets going forward. In other words, supply constraints of one kind or another may be on the horizon for years, keeping the rate of inflation higher than the Fed’s 2% target.

Americans and their political representatives won’t like hearing that. They regard inflation as the theft of their hard-earned purchasing power. “We’ve got a hell of a mess here, OK?” the colorful Louisiana Republican Senator John Kennedy told Powell at a hearing in June. “Inflation is hitting my people so hard, they’re coughing up bones.” If Louisianians start losing their jobs when the Fed raises rates enough to crush demand, Kennedy’s next metaphor might get even darker.

Powell had bipartisan support to bring inflation lower. But as he’s moved to a more aggressive posture, calling the labor market “ extremely tight” and hinting at a willingness to see unemployment rise, senior Democrats are protesting. Of course, they need to win more seats in the midterms to assure that their ambitious agenda gets passed. “What’s worse than high inflation and low unemployment?” Senator Elizabeth Warren (D-Mass.) asked Powell during congressional testimony in June. “It’s high inflation and a recession with millions of people out of work.” She added, “I hope you’ll reconsider that before you drive this economy off a cliff.”

There are already signs that rates are starting to bite. Existing home sales fell in June for a fifth month to a two-year low as mortgage rates jumped, and the economy slumped in the second quarter. The big mystery remains the robust labor market, which the Fed is now watching closely. Job gains in April through June averaged 375,000 per month. Economists estimate the pace will slow to 250,000 jobs added for July, but that’s still pretty strong.

So how does all this monetary policy experimentation end?

The Fed itself is wondering that, too, says Laurence Meyer, a former Fed governor. He says policymakers haven’t been entirely clear whether they think inflation gets resolved through the improved supply of goods and workers or just much lower demand.

Increasingly, Powell and his colleagues are communicating that they can no longer wait for supply to resolve itself. That leaves them no choice but to keep raising rates—this is a baseball bat, gorilla!—until demand starts to falter. “It is hard for a Federal Reserve member to say, ‘Yeah, to get inflation down we have to put people out of work,’ ” says Meyer, who runs a policy analysis company in Washington that bears his name. “If you are going to do whatever it takes” to get inflation lower, he says, “recession has to be a policy option”—even if Powell doesn’t want to be explicit about that.

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