Even a recession might not tame inflation

The market has spoken: It's expecting that the Federal Reserve's fight against inflation is just about over. Fed Chairman Jay Powell has hinted that rate increases are nearly at an end. But inflation was still at 6% last count, and Powell insists the Fed is still committed to reaching its 2% target.

He may be thinking — along with some other economists — that the Fed has already done enough. After all, interest-rate increases can take a few years to ripple through the economy and lower inflation. The current banking turmoil could be the first sign of that starting to work. Forecasters have swung away from a soft landing for the economy and are again predicting an imminent recession, which should put the final nails in inflation's coffin.

Unfortunately, we can't count on a recession to solve our inflation problem. Odds are, the Fed still has more work to do if it's serious about getting inflation back to 2%.

How monetary policy affects the economy and inflation is not that well understood. Tighter Fed policy reduces the money supply, which is presumed to lower inflation just because there is less money sloshing around. But as former New York Fed President Bill Dudley explained, after the Fed started paying interest on the bank reserves it holds, the money supply became less important because it severed the relationship between the money supply and credit.

Nonetheless, a higher policy rate is presumed to contract the economy because it makes credit scarcer and more expensive. This means less investment, more failing firms, fewer people buying or building homes, and ultimately higher unemployment. At this stage workers get smaller raises, if they get them at all, and people are generally more pessimistic and spend less. Hence, demand falls and brings down inflation. Or so the thinking goes.

There are a lot of moving parts here, and as the last three years have demonstrated, things don't always work as you expect. There is a possibility we could get a recession and still have high inflation — essentially a return of the 1970s stagflation. This could happen if a recession comes with another supply shock, like a pull-back in trade or an increase in energy prices. Some economists argue that the 1970s stagflation was due to expansionary monetary policy, which means that if a recession prompts the Fed to cut interest rates or restart quantitative easing before inflation is subdued, we could end up with high inflation and a recession.

Another possibility is that a recession lowers inflation some, but not very much. Economist Jason Furman recently pointed out that the last few recessions only brought inflation down between 0 and 1.9 percentage points.  Right now we need inflation to fall more than 2.5 points to get back to the Fed's target.  Of course, every downturn is different, and the more severe it is the more it will lower inflation.

But we don't know exactly how bad a recession has to be to fix inflation. It's been more than 40 years since we've had a serious bout of inflation and a lot has changed in that time. Economists estimate that in the past, it typically took a 2% and 3% fall in GDP to bring inflation down 1 percentage point. But because the relationship between the unemployment rate and inflation has become weaker since the 1980s, a much stronger contraction may be necessary today. The Fed is assuming that unemployment will need to peak at 4.6% to bring inflation down to 2%. But this seems wildly optimistic. If previous bouts of inflation are any guide, it will take a much bigger drop in GDP to get inflation to 2%.  Former Treasury Secretary Larry Summers argued last fall unemployment would need to go to 6%.

So a mild recession, or the low-growth scenario the Fed is trying to engineer, probably won't be enough to achieve the 2% target. It wouldn't have been enough in the 1980s and there are reasons to believe it will be even less effective now, because while a credit contraction will do some harm, the economy is still fairly resilient. Household and corporate balance sheets are still in good shape from the pandemic. Many households locked in low mortgage rates and their housing decisions aren't too sensitive to rates anymore.

The other reason a Fed-induced recession might not work is that the Fed has lost some of its credibility. Higher rates have more impact when people believe the Fed has the power and determination to lower inflation. When people expect inflation to be low, they don't increase prices or demand big pay raises. But if people still expect high inflation, a recession — especially a mild one — won't be enough to bring it down.

One sign of hope is that bond market indicators for inflation expectations are pointing to less inflation. But the bond market has a terrible track record predicting inflation. The fact that markets are pricing rate cuts when Fed governors are still talking about increases suggests the Fed's credibility is running low.

If that's the case, a recession may damage the economy and boot people out of their jobs without doing much to budge inflation. The Fed will be in an even tougher spot: bring on even more pain, or learn to live with higher inflation.

Allison Schrager is a Bloomberg Opinion columnist covering economics. A senior fellow at the Manhattan Institute, she is author of "An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk." @AllisonSchrager

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.