Economists increasingly fear the Fed is now pushing the U.S.—and world–into a deeper than needed recession, risking millions of jobs and market stability. During Volcker’s reign, unemployment stayed above 10% for nine straight months and the mortgage rate hit nearly 17%.
Some months after Jerome Powell became Federal Reserve Chair in early 2018, the former attorney and longtime investment banker began carrying around a new memoir by Paul Volcker: Keeping At It: The Quest for Sound Money and Good Government. “I actually thought I should buy 500 copies of his book and just hand them out at the Fed,” Powell quipped at a conference in October 2019, just two months before Volcker passed away at 92. “I didn’t do that, but it’s a book I strongly recommend, and we can all hope to live up to some part of who he is.”
It was a gracious, but arguably consequence-free tribute by Powell. After all, inflation was then running at just 2% and the towering (6’7”), cigar-puffing Volcker was most famous for taming the stubbornly high inflation that plagued the United States in the 1970s and early 1980s—and driving the economy into a painful double-dip recession while doing it. No need to emulate that.
But now Powell is facing the sharpest inflation spike in 40 years and some critics worry he may be hewing too closely to an outdated Volcker playbook, tightening too-fast and too long and spurring a deeper-than-needed recession at home and abroad. Repeatedly this year, Powell has alluded to the title of Volcker’s memoir when discussing the duration of interest rate hikes, pledging the Fed must “keep at it” until inflation slows. He has insisted the stop-and-start Fed policy, led by Volcker predecessor Arthur Burns in the 1970s, was a mistake because it bred stagflation—that is, prolonged inflation in addition to stagnant growth—making it even more difficult to tame skyrocketing prices.
On Wednesday, Fed officials hiked interest rates by 75 basis points for a fourth-straight time in six months, pushing the key federal-funds rate (that’s the rate at which banks lend to each other, not to consumers or businesses) to a target range of 3.75% to 4%—the highest level since the Great Recession.
In their formal announcement, officials hinted they may slow the pace of hikes in December, saying they will take into account “the lags with which monetary policy affects economic activity” in determining future increases. But Powell, in the press conference that followed, didn’t back away from his hawkish stance, saying the latest economic data suggests the Fed may ultimately move rates to higher levels than it projected in September and that the risk is doing too little rate-hiking, not too much.
“We want to get this exactly right, but if we over-tighten, then we have the ability with our tools to support economic activity strongly,” Powell said. “On the other hand, if you make a mistake in the other direction, and you let this [inflation] drag on a year or two, the risk is that it becomes entrenched in people’s thinking.” That’s what happened in the 1970s and early 1980s, as expectations of high inflation became entrenched and workers (many more of them unionized back then) demanded higher raises to cover future inflation.
“The ghost of Paul Volcker is back at the Fed,” laments former Fed economist Claudia Sahm, the founder of Sahm Consulting. She criticizes the central bank for “backing itself into a corner” by insisting it will keep to its aggressive policy until the consumer price index (a lagging indicator of inflationary trends), comes down meaningfully over several months. “They’re really in the 70s, and they’re worried about making the mistake Volcker did in the first recession of pulling out too fast,” she says, referencing the former chair’s decision to loosen up policy in early 1980—only to see inflation once again surge later in the year, necessitating more tightening and another, steeper recession–the second dip. “But at this point, it’s absolutely absurd,” Sahm adds, pointing to forward-looking indicators, including producer prices that were flat in September, as signs inflation is abating and inflationary expectations aren’t yet becoming entrenched.
Sahm is a well-known inflation dove. But some middle-of-the-road and even traditionally hawkish inflation watchers now see risks that the Federal Reserve will wait too long to slow or pause its dramatic tightening.
“Further tightening beyond November seems unnecessarily risky,” Ian Shepherdson, founder and chief U.S. economist of Pantheon Macroeconomics, said before Wednesday’s widely-expected hike. Notably, he correctly predicted back in 2020 that rates would have to rise in 2022 and early this year predicted that housing would take an interest rate driven hit. The first half of 2023 will be exposed to the “full force” of the tightening conditions, with the risk that the economy will “likely shrink outright” and fall into a recession. Even Volcker stopped raising rates before inflation peaked (by two months in 1980 and three months in 1981), he notes.
A Bloomberg survey of economists released last week found three-quarters believe the Fed will act too aggressively, eventually triggering a global recession. “No one knows whether there’s going to be a recession or not, and if so, how bad that recession would be,’’ Powell said Wednesday. “The inflation picture has become more and more challenging over the course of this year, without question. That means that we have to have policy be more restrictive, and that narrows the path to a soft landing.”
One big reason that the Fed could overshoot is that monetary policy itself (as the Fed nodded to in Wednesday’s statement) works with long and variable lags, making it difficult to judge when interest rates have reached the level needed to bring inflation down, notes British investment firm Schroders. It adds that a rate hike today can take up to two years to fully ripple across the economy. “It’s going to be painful,” laments Jason Vaillancourt, a global macro strategist at Putnam Investments, who predicts it won’t be until 2023’s second or third quarter that the U.S. economy sees “the real impact of the lagged effect of tightening in a meaningful way.”
In October, Harvard professor Greg Mankiw, a conservative economist who headed up President George W. Bush’s Council of Economic, cited monetary lag as one of several reasons he believes “the Fed may be overdoing it.” Others include simultaneous tightening in Europe, structural economic changes since Volcker’s day and an already sharp slowdown in the growth of the money supply.
There’s also the risk that Powell is showing a natural human tendency to overcorrect for his slowness to react to inflation—for most of 2021, he described the rise in inflation as “transitory” and the Fed waited until prices were rising at the fastest pace in 40 years to start hiking rates in March 2022. To be fair, Powell could not have predicted the waves of Covid that exacerbated supply chain constraints last winter, nor the war in Ukraine that pushed oil prices to a seven-year high in March, but many others got off the transitory bandwagon sooner. “At this point, a recession seems a near certainty due, in part, to the Fed’s previous miscalculations that led monetary policy to be too easy for too long,’’ Mankiw blogged. “There is nothing to be gained from making the recession deeper than necessary. The second mistake would compound, not cancel, the first one.”
Even Powell’s critics aren’t predicting anything quite so painful as the Volcker recessions, which the majority of Americans (median age 38.8) don’t remember. When Volcker took office in August 1979, inflation was running at a 12% annual rate, after two energy shocks (the Arab oil embargo beginning in 1973 and the Iranian revolution beginning in 1978), and years of large deficits and accommodative Fed policy. President Jimmy Carter elevated Volcker from his job as president of the Federal Reserve Bank of New York precisely because he was known as an inflation hawk. And he didn’t disappoint.
Determined to keep inflation from becoming even more entrenched, Volcker quickly started raising interest rates and then took the out-of-favor monetarist approach of tightening the money supply. But he eased up in 1980 after the country entered a recession. In the fall of 1980, he started tightening again, focusing on money supply and driving the federal funds rate to a record high of more than 22% and mortgage rates to nearly 17% in the process. Unemployment stayed above 10% for a painful 9 months and peaked at 10.8% in November 1982– higher than the 10% peak during the Great Recession that lasted from December 2007 to June 2009. (While the Covid-19 shutdowns and recession pushed unemployment up to a startling 14.7% in April 2020, the rate then fell rapidly and now sits at 3.5%)
Volcker faced protests, Congressional threats of impeachment, and even physical threats that prompted the Fed to insist he get a bodyguard. But he stood his ground and later denounced inflation as “maybe the cruelest tax”—one with a wide-spread toll across sectors and a tendency to “hit poorer people more than richer people.” After peaking at 14.8% in early 1980, inflation started steadily falling–down to 8.4% in January 1982 and 3.7% a year later.
Still, the negative impacts of the Volcker inflation crackdown weren’t limited to the U.S. or unemployment. Among other things, rising U.S. interest rates helped kick off a debt crisis among Latin American governments which had borrowed excessively from U.S. banks.
Powell clearly has had his inflation-busting work cut out for him, but this cycle’s apparent inflation spike—at 9.1% in June—doesn’t rival the top rate Volcker faced. Moreover, the public (in a monthly survey by the New York Fed) still seems to believe inflation will come down quickly from its current 8.2% rate–falling to 5.4% in a year and 2.9% in three years.
Though employment has remained strong (a factor supporting Powell’s hawkishness), already the stock market has braced for a slowdown. After soaring 27% in 2021, the S&P 500 is down 21% this year, despite big October gains. Most analysts predict the drop will only steepen if the economy plunges into a recession. Vincent Deluard, a global macro strategist at investment firm StoneX, forecasts earnings across the S&P will shrink by 7.4% over the next year—threatening to tank the index by as much as 24% to 2,950 points by the end of next year. Others are a little less bearish: Goldman Sachs projects the S&P could plunge another 13% to 3,400 points by the end of the year and 19% to 3,150 over the next six months—taking a full year to recover its losses in the event of recession.
On Wednesday, the stock indexes first rallied on the Fed’s formal statement, then sank after markets heard Powell’s hawkish words, with the S&P off 2.5% for the day.
Still, the stakes are higher than what might happen to the value of Americans’ 401(k)s. “The Fed is moving at the pace that it believes is optimal to reduce inflation, but it may eventually turn out to be too rapid,” says EY chief economist Gregory Daco. He believes the hikes will create a “disorderly” tightening of financial conditions and likely force the economy into a recession by the end of this year, or early next. As a result, the unemployment rate could rise to 5.5%—leaving nearly 3 million people unemployed next year, EY forecasts.
Meanwhile, the resulting impact of global tightening could be worse abroad. “The world is headed toward a global recession and prolonged stagnation unless we quickly change the current policy course of monetary and fiscal tightening in advanced economies,” the United Nations warned in a report last month, adding that “alarm bells are ringing most” for developing countries loaded with debt and edging closer to a potential default, with interest rates hikes in advanced economies hitting the most vulnerable the hardest.
By making the dollar stronger relative to foreign currencies, this year’s Fed hikes alone could cut $360 billion of future income for developing countries, the UN estimates. “It’s dangerous,” says Sahm, noting “the stakes are a lot higher than the 1970s” as regions like Europe aim to support Ukraine in its fight against Russia, and further cautioning the tightening could fuel a global food crisis in poorer countries.
“The more the Fed tightens, the more it creates these knock-on effects—these spillover effects—domestically and internationally, and the more it increases the risk of a hard landing and recession,” says Daco.
At this point, the biggest question for many economists is when the Fed will slow or stop its rate increases–and that date has been slipping into the future. In a note this past weekend, the team led by Goldman chief economist Jan Hatzius said the Fed will be more hawkish than previously forecast, hiking past its February meeting to a federal funds top rate of 5%. (Last December, the Fed had projected it would only need to raise rates to 3.1%.)
Powell on Wednesday insisted it’s “premature” to discuss pausing hikes, saying: “It’s not something we’re thinking about” and refusing to provide a specific timeline. Goldman expects officials will dole out a half-point hike in December, followed by quarter-point hikes in each of February and March before pausing to assess financial conditions.
But a growing number of experts say it could take a large financial market disruption to force an actual pause. Such as? As yields on the 30-year Treasury leap up, policymakers could be getting more concerned about poor liquidity in the Treasury market, Bank of America credit strategist Yuri Seliger wrote in a note last week, pointing out Secretary Janet Yellen said the Treasury was “closely monitoring the financial sector” after volatility increased. Additionally, a “precipitous drop in housing prices” has raised financial stability concerns and could potentially result in too much tightening in the housing sector, a key part of the U.S. economy, Seliger observed.
For now, however, it’s too soon to tell when the Fed will pause or pivot—or what may cause it to do so. One thing that’s more certain: It may take a while, at least according to Fed officials.
“This idea—that markets keep expecting this pivot, and then the Fed keeps pushing back on the pivot—is kind of comical, because they’ve been extraordinarily transparent,” says Vaillancourt. “They’ve said, ‘Look, we need to get to restricted territory and stay there for a while.’ and I would take them at their word.”