Discussion
Former FRB New York President Bill Dudley has been a key FED communication channel since this tightening cycle began in late 2021, and his July 14, 2022 Bloomberg op-ed was formative in my thinking around the Fed’s anti-Burns reaction function - that being, the Fed will maintain tight monetary policy deep into a recession, thus exacerbating the ultimate economic and equity market fallout. The key passage was:
“…the Fed needs to be confident that it has succeeded in pushing inflation back down on a sustainable basis. Chair Powell correctly understands that the costs of not hitting the 2% target over the next year or two outweigh the costs of a mild recession – because failure would cause inflation expectations to rise, necessitating an even tighter monetary policy and a deeper downturn later. In the late 1960s and the 1970s, the central bank tightened monetary policy enough to push inflation lower at times, but it reversed course too soon. As a result, the peaks and the troughs for inflation kept moving higher — until the 1980s, when Paul Volcker had to force a deep recession to regain control. Given this history, officials will be hesitant to stop tightening until they’re highly confident (probability greater than 80%) that they’ve done enough — that the labor market has sufficient slack to keep inflation low and stable, and that easing financial conditions won’t lead to a inflation rebound.”
Dudley’s July 14, 2022 op-ed was prophetic, as the passage quoted above was almost verbatim the framework Chair Powell rolled out in his now infamous Jackson Hole reset of the market’s view of the Fed’s resolve to bring inflation back to 2% on a sustained basis. In short, when Dudley speaks, listen.
Soft Landing Analysis
Today Dudley is out with a Bloomberg op-ed analyzing the case for a soft landing as defined by consensus (i.e. a no-recession outcome while inflation falls back to the Fed’s 2% target via supply-side “healing”), an excellent addendum to the “Soft Landing Dynamic. Hard Landing Outlook” piece I wrote yesterday.
His analysis asks and then answers three questions:
Will the effects of the Fed’s tightening keep mounting, thanks to lags in monetary policy?
Once those lags have played out, will the Fed’s stance be sufficiently tight to keep growth in check?
Does the unemployment rate need to go much higher to bring inflation back down to the Fed’s 2% target?
Shorter Lags
“There’s considerable evidence that lags have shortened, meaning that the economy has already felt nearly all of the impact of the Fed’s actions. This makes sense in a world where the central bank communicates its plans well in advance.
“The expectation that the Fed will soon be done tightening, for example, has already eased financial conditions more broadly…”
Higher Neutral Rate
“…there’s a compelling case to be made that the ‘neutral’ level of short-term interest rates (the level that neither constrains nor stimulates growth) has increased. If so, monetary policy may not be as restrictive as currently believed and the Fed may have to take its target rate higher than 5.25% to 5.50% to push up the unemployment rate significantly.”
4.5% Unemployment Rate
“…the median projection as of June was for the unemployment rate to rise to 4.5% next year, almost a percentage point higher than it is today. I wouldn’t expect that outlook to change without considerable evidence that the economy can operate at an unemployment rate below 4% and that can be consistent with 2% inflation on a sustained basis.”
Not one scintilla of Dudley’s analysis will come as a surprise to anyone who pays close attention to what FED Chair Powell actually says when it comes to his desire to engineer a “soft landing”. Nevertheless, it’s useful to review. Here’s Powell at last week’s press conference:
As I said yesterday, Powell tends to wrap hawkish guidance with dovish musings - so, one could interpret his “we’re [not] aiming to raise unemployment” as dovish. But that comment is not even 1% of the totality of the message communicated and actions taken tightening cycle to-date. As David Rubenstein said back in April, the Fed needs to see the unemployment rate rise to 5-6% to ensure inflation is back to 2% on a sustained basis.