There Is No Fed Magic Trick to Achieve a Soft Landing
Economic growth in the United States accelerated to a 2.4 percent annualized rate in the second quarter of 2023, picking up from 2.0 percent in the first quarter, and climbing well above the 1.8 percent rate predicted by economists. Many analysts are surprised that the US economy has continued to expand at a robust pace despite the Federal Reserve’s (Fed) aggressive tightening on monetary policy.
The Fed raised interest rates by more than 500 basis points (bps) since March 2022. And yet, the labor market remains tight with a very low unemployment rate at 3.6 percent while the Standard and Poor 500 stock index is up almost 20.0 percent since the beginning of the year. Economists are optimistic that the Fed could deliver a soft landing by reducing inflation close to the 2.0 percent target while avoiding a recession. But will the Fed’s magic really work?
Insufficient Monetary Tightening
Since the financial crisis of 2008, the Fed had followed an “easy money” policy, but during the pandemic, the Fed leaned even further into this stance. As Consumer Price Index (CPI) inflation accelerated toward 5.0 percent, Fed Chair Jerome Powell belatedly admitted that inflation wasn’t transitory and shifted course. In March 2022, the Fed started raising interest rates but could not prevent inflation from surging to a peak of 9.1 percent in June 2022.
In 2022, it became apparent that the Fed’s tightening on monetary policy was not hawkish enough and that it was more concerned with avoiding a recession and instability of the financial sector. The interest rate hikes were piecemeal, and largely insufficient, as the real interest rate (the difference between the federal funds rate and the inflation rate) remained negative until April 2023 (figure 1).
The current positive real interest rate of about 2.0 percent is still rather low by historical standards and likely continues to artificially stimulate growth. Headline CPI inflation, helped by declining energy prices, may have decelerated to 3.1 percent in June but remains above the Fed’s 2.0 percent target. Moreover, core inflation—which excludes volatile food and energy prices—was at a sticky 4.8 percent in June as wage increases sustained strong consumer spending and second-round inflationary effects.
Figure 1: Federal funds rate and CPI
Source: Data from the Board of Governors of the Federal Reserve System and the Bureau of Labor Statistics.
Most important, the Fed cannot rely only on interest rate hikes to tighten monetary policy. It needs to also shrink its balance sheet via quantitative tightening (QT) to reverse its previous quantitative easing, a policy of massive purchases of Treasury and mortgage-backed securities to boost commercial banks’ reserves and liquidity while lowering longer-term interest rates. Quantitative easing made the Fed’s balance sheet explode to a whopping $9 trillion, as of May 2022 (figure 2), and analysts agree that by reducing bank reserves, QT should exert upward pressure on interest rates while curtailing lending.
Figure 2: Total Fed assets (millions)
Source: Data from the Board of Governors of the Federal Reserve System.
In June 2022, the Fed started implementing its QT policy by shedding its holdings of US Treasuries and mortgaged-backed securities a
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