US | Disinflation without a deep recession: the big challenge of the Fed

Summary

Since the decade of the 1970s a strong surge in US inflation had not been seen. Even though there are some similarities between those years and nowadays like the higher inflation of food and energy, the Fed back then was not truly independent and used to favor employment expansion at the expense of inflation.

Key points

• Key points:
• The lack of Fed’s credibility over the decade of the 1970s made the reduction of inflation more costly. Out of the economic recessions induced by the Fed since 1965, the more costly ones correspond to those that began in 1973, 1980 and 1981 with GDP contractions of 2.7%, 2.2% and 2.1%, respectively.
• The Fed projects an increment of two percentage points in the federal funds rate to lower inflation from 8.6% (posted in May 2022) to 2.2% by the end of 2024, an unemployment rate that will change from 3.6% to 4.1% in the same period and a moderation of economic growth to just under 2.0% for 2022-24.
• Nevertheless, if the Phillips curve has shifted outwards after the pandemic and workers are compensating most of the higher inflation of recent months, it is very likely that an unemployment rate higher than 4.1% will be needed to reduce inflation significantly.
• The Fed will have price stability in the following months as a priority to avoid a costly loss of credibility that could subsequently imply a significant economic contraction to control inflation.
• A soft landing continues to be possible and very likely, although it will be more difficult to accomplish if the factors that determine inflation made it more persistent.

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