The Tradeoff: Inflation vs. Growth
The Federal Reserve now must choose between infla- tion and eco- nomic growth, and indications are it will sacrifice growth to reduce inflation. Since the financial crisis, the Fed hasn’t had to make this choice. Long- term factors contained inflation. There was little risk monetary stimulus would trigger an inflationary spiral. Things are different now.
As I said in this month’s introduction, the old nor- mal is returning. The Fed is likely to have to weaken growth, perhaps even trigger a recession, to bring inflation down to its 2% target. The Fed has deliberately been behind the curve on inflation. The U.S. central bank’s leaders feared a recession so much they let inflation rise and con- vinced themselves the forces pushing prices higher were transitory. Fed officials finally recognized inflation is painful and persistent, needing to be curtailed.
On March 21, Fed Chairman Jerome Powell essen- tially said in a speech the Fed would do whatever it takes to reduce inflation. Since then, other Fed officials have prepared the markets for more aggres- sive interest rate increases and reduc- tions in the Fed’s balance sheet (known as quantitative tightening) than its leaders previously forecast, and more than the markets expected. Other factors were reducing economic growth before the Fed took any action.
Most of the pandemic fiscal stimulus programs ended in 2021, and markets began increasing interest rates long be- fore the Fed did. Rising commodity pric- es and supply shortages of both goods and labor also are reducing growth. Falling stock prices also hamper economic growth. The Fed depended on the wealth effect to increase growth in the year following the financial crisis. The Fed’s stimulus pushed stock prices higher, which gave people confidence to spend more than they would have.
Since the Fed now is more concerned about inflation than growth, it’s no longer supporting stock prices. It is starting to drain liquidity from the economy, and that will reduce some of the sup- port for stock prices. I expect continued weakness in the stock indexes, but especially in the growth stocks that reached very high valuations in 2021. Demand for the U.S. dollar also is likely to fall, reducing both growth and support for stock prices.
The invasion of Ukraine trig- gered a range of economic sanctions by the United States and European nations. A result is that Russia, China and other potential adversaries are looking for alternatives to the dollar to limit the effects of future sanctions. While those factors slowed the growth rate, the economy and inflation still have a lot of momentum. Businesses continue to rebuild inventories after the surge in demand and supply shortages depleted them. Capital spending by businesses also is strong, making up for low levels of recent years. The labor market remains strong, keeping wage growth high and stimu- lating spending. High home prices also encourage spending by households.
On balance, it’s likely growth will re- main positive and inflation will remain well above the Fed’s 2% target unless the Fed takes significant actions. Fed officials realize they no longer can be behind the curve on inflation. Inflation clearly is self-sustaining and has become painful for many house- holds and businesses. Despite the highest compensation increases in years, incomes are losing purchasing power to inflation. The Fed recognizes it needs to be serious about inflation, even if that hurts economic growth. In the first quarter of 2022, even before the Fed took meaningful actions, market interest rates rose the most in a quarter since at least 1980.
Yet, nominal interest rates will con- tinue to increase for a while, hurting prices for bonds and other fixed-in- come investments. The Fed needs to get serious about inflation. As in the past, it’s likely to go too far and push the economy into a recession at some point.
