Insight: three reasons for the Fed’s soft landing

Between 2021 and early 2022, a group of prominent Harvard economists, including Lawrence H. Summers, Jason Furman, and Kenneth Rogoff expressed criticism of the tax program and investment promoted by the Biden administration. These economists have pressured the US Federal Reserve to raise interest rates. Their main argument was that rising inflation, fueled by federal spending, would be persistent, necessitating a transition to more austerity policies.

This group of economists, along with other commentators who shared their views, failed to influence either the White House or Congress. However, they found an ally in the chairman of the Federal Reserve, Jerome Powell, and his colleagues, who began raising interest rates in early 2022 and have maintained this policy. This sudden tightening of monetary policy by the Federal Reserve raised concerns among progressives, led by Senator Elizabeth Warren of Massachusetts, who feared that it could lead to a recession, a rise in mass unemployment and, even if they have not explicitly said it, to a possible Republican victory in the 2024 elections.

However, the current macroeconomic situation has confused both positions. Contrary to the predictions of austerity advocates, inflation peaked in 2022, largely due to the sale of US strategic oil reserves. There has been no persistence in expected inflation following fiscal 2021 spending, nor has there been a surge in wage-driven inflation, despite low unemployment. The models and historical precedents referred to by the group of Harvard economists no longer appear to apply.
Furthermore, there has not been a recession, unemployment has not increased, and higher interest rates have not discouraged business investment. Although the residential construction sector took a hit, the overall construction sector soon regained momentum, and the banking crisis earlier in the year did not lead to financial contagion.

These surprising circumstances led some observers to congratulate Powell and the Federal Reserve for achieving a soft landing. However, giving all the credit to the Federal Reserve would be an illusion. There is no theoretical basis or precedent that 18 months of rising interest rates starting in January 2022 could have caused inflation to collapse by July of that year. Progressives and austerity enthusiasts alike now face a conundrum: Why hasn’t monetary tightening had a significant impact on jobs, investment, or economic growth?

A possible answer to this can be found in new tax incentives for investments, particularly in the semiconductor and renewable energy sectors. However, these sectors are relatively small, and their growth may have created at most one hundred thousand jobs. Another explanation may lie in direct investments by companies fleeing Europe’s industrial decline, which was partly caused by sanctions against Russia. But even then, these numbers do not appear to be significant enough to explain the current situation.
An important factor, suggested by Robert Aliber, professor emeritus of international economics and finance at the University of Chicago, is that the top quartile of US households has accumulated considerable wealth during the pandemic. These households make up a significant portion of U.S. purchasing power, and their spending is largely independent of interest rate movements.

Another hint comes from Warren Mosler, known as the father of Modern Monetary Theory, who noted that the US national debt has increased to nearly 130% of GDP, up from 60% in the early 2000s. Net interest paid on this debt grew 35% from 2021 to 2022, representing 2% of GDP, and about 70% of these payments went to the U.S. private sector. If we also consider the interest paid on $3 trillion in bank reserves since 2008, the fiscal effect of this channel has been notable.
History offers us interesting insights to understand the current situation. In 1981, US federal debt was only about 30% of GDP, and much of it consisted of long-term, interest-free fixed-rate bonds on bank reserves. As a result, then-Federal Reserve Chairman Paul Volcker’s dramatically high-interest rate increases primarily affected private debtors and corporate investments. Additionally, the tax impact of interest payments has been limited.

In contrast, when federal debt exceeded 100% of GDP in 1946, much of it was war bonds held by U.S. households. Although these bonds yielded only 2% interest, they helped support private incomes and provided a basis for mortgage indebtedness, contributing to a period of middle-class prosperity in the 1950s.
The concept of a fiscal channel for interest payments may be uncomfortable for those who raise concerns about government debt. It suggests that Powell’s interest rate increases may not be enough to slow the economy. Indeed, further rate increases could even have expansionary effects, at least up to a point.

As in other extreme situations, for example in Argentina, where interest payments make up more than a quarter of GDP, interest rate increases increase costs for businesses, push up prices and put pressure on prices of resources (land, minerals, oil), which in turn influence inflation. This can discourage saving, stimulate lending, and push the Federal Reserve to raise rates further.
In the long run, this process can lead to economic chaos. However, if this analysis is correct and high-interest rates do not lead to the recession the Federal Reserve seems to desire, it may be difficult to change course.

What could be the solution? One possible response could be a severe fiscal austerity policy, with budget cuts aimed at provoking the recession that interest rates failed to trigger. There is already growing pressure for this option from Wall Street. Last week, Fitch downgraded the credit rating of US sovereign debt, a clear attempt to put pressure on Congress ahead of its budget deadlines. However, a policy change of this magnitude, if implemented decisively, could lead to a further weakening of the American middle class.

Of course, a better solution would be to strengthen the middle class and reduce the power of financial institutions. This could mean lower interest rates through regulation of credit flows, strategic price controls, and greater fiscal support for household incomes and well-paid jobs. People with secure incomes can reduce their dependence on unstable loans.

In conclusion, the current economic situation in the United States is complex and defies conventional predictions and theories. As economists continue to debate the causes and effects of rising interest rates and inflation, it is clear that flexible solutions will be needed to address evolving economic challenges.

Original article published on Money.it Italy 2023-09-16 07:00:00. Original title: Le tre ragioni del soft landing della Fed