WASHINGTON – Last year's spike in inflation, to the highest level in four decades, was painful enough for American households. Yet the cure — much higher interest rates, to cool spending and hiring — was expected to bring even more pain.
Grim forecasts from economists had predicted that as the Federal Reserve jacked up its benchmark rate ever higher, consumers and businesses would curb spending, companies would slash jobs and unemployment would spike as high as 7% or more — twice its level when the Fed began tightening credit.
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Yet so far, to widespread relief, the reality has been anything but: As interest rates have surged, inflation has tumbled from its peak of 9.1% in June 2022 to 3.7%. Yet the unemployment rate, at a still-low 3.8%, has scarcely budged since March 2022, when the Fed began imposing a series of 11 rate hikes at the fastest pace in decades.
If such trends continue, the central bank may achieve a rare and difficult “soft landing” — the taming of inflation without triggering a deep recession. Such an outcome would be far different from the last time inflation spiked, in the 1970s and early 1980s. The Fed chair at the time, Paul Volcker, attacked inflation by escalating the central bank's key short-term rate above 19%. The result? Unemployment shot to 10.8%, which at the time marked its highest level since World War II.
A year ago, in a high-profile speech, Chair Jerome Powell warned that the Fed was prepared to be similarly aggressive, saying its rate hikes would cause “some pain” in the form of higher unemployment. The Fed, Powell said pointedly, would “keep at it,” a play on the title of Volcker's autobiography, “Keeping At It.”
Over time, as the job market has displayed surprising resilience, Powell has adopted a more benign tone. At a news conference last week, he suggested that a soft landing remains a “possible," if not guaranteed, outcome.
“That’s really what we’ve been seeing," he said. “Progress without higher unemployment, for now.”
How have the Fed's rate hikes managed to help substantially slow inflation without also causing dire consequences? And can the job market and the economy maintain their durability even with the Fed intending to keep borrowing rates at a peak well into 2024?
Here are some reasons for the economy's unexpected resilience and a look at whether it might endure:
REPLENISHED SUPPLIES HAVE HELPED COOL INFLATION
The idea that defeating high inflation would require sharply higher unemployment is based on a long-time economic model that may prove ill-suited for the post-pandemic episode.
Claudia Sahm, a former Fed economist, suggested that those who assumed that surging unemployment was a necessary price to pay for conquering inflation believed that the price spikes of the past 2 1/2 years were driven mostly by overheated demand. Shut-in consumers did ramp up their spending on patio furniture, exercise bikes and home office equipment as stimulus checks landed in their bank accounts.
But to quell demand-fueled inflation, the Fed's policies would have needed to crush spending, causing sales to plunge and forcing businesses to cut jobs. Yet inflation has cooled even as Americans as as whole have continued to spend freely on shopping, traveling and entertainment.
“The fact that we have the economy healing without unemployment moving up, without consumption slowing a lot — that suggests that really the driver of this was something else," said Alan Detmeister, a former Fed economist now at UBS.
Detmeister and other economists increasingly think that the supply disruptions of the pandemic and Russia's invasion of Ukraine played the biggest role in accelerating inflation. Even as spending on goods soared, spending on services declined, leaving overall demand roughly in line with pre-pandemic trends.
This inflationary episode, Detmeister said, may end up more closely resembling the one that occurred after World War II than the one of the late 1970s and early 1980s. After World War II, manufacturing output slowed as factories retooled from wartime production. At the same time, many returning servicemembers moved to the suburbs, and demand spiked for homes, appliances and furniture. Even so, inflation eased once output resumed.
In a recent study, Mike Konczal, a director at the Roosevelt Institute think tank, found that the prices of nearly three-quarters of goods and services have declined as quantities have increased. This suggested to him that rising supplies have been the primary reason why inflation has declined. (The figures exclude volatile food and gas prices in order to capture underlying trends.)
It's unclear how much longer this trend can continue to help slow inflation. Susan Collins, president of the Federal Reserve Bank of Boston, said Friday that the supply rebound has indeed eased inflation in goods. But the cost of most services, she said, “has yet to show the sustained improvement” that's needed to bring inflation down to the Fed's 2% target.
Konczal remains optimistic. Inflation is slowing in many services categories, including restaurants, laundry services and veterinary care, even without much of a drop in demand.
“The disinflation we're seeing," he wrote in his study, “is therefore broad and could continue.”
THE JOB MARKET HAS CHANGED
Another supply improvement has occurred in the job market: The supply of labor. Since the Fed began raising rates last year, about 3.4 million people have begun looking for work. One big driver factor has been a rebound in immigration that followed the easing of pandemic-era restrictions.
And more job-seekers are still coming off the sidelines. The proportion of adults in their prime working years — ages 25 through 54 — who either have a job or are looking for one has reached its highest point in two decades.
At the same time, businesses appear to need fewer workers. But instead of cutting jobs, they are seeking fewer new employees. The number of open jobs has sunk from more than 12 million last year to 8.8 million in July, though it's still well above its pre-pandemic level. And fewer people are quitting jobs in search of higher pay elsewhere.
Powell noted last week that fewer job openings and more workers mean the labor market has been brought into better balance. This has taken the pressure off companies to raise wages to find and keep workers. Still, with inflation having eased, hourly pay is now growing faster than prices.
Even among businesses that worry about the economic outlook, many are more reluctant to cut jobs than in the past. Jay Starkman, CEO of Engage PEO, which provides human resources services to small companies, said many employers seem “hung over” from the rapid layoffs and then rapid rehiring that occurred during and after the pandemic recession of 2020.
“Employers today are saying, ‘Well, my business is a little down. I can stomach holding on to these employees for now. I really don’t want to go through having to find and then train good employees again.' ”
CONSUMERS AND BUSINESSES HAVE KEPT GOING
Another reason why high interest rates haven't caused unemployment to jump is that many households and companies were better insulated from rate hikes than in the past.
Americans as a whole saved a sizable chunk of the thousands of dollars of stimulus checks and enhanced unemployment benefits they received during the pandemic. Those savings helped propel consumer spending well into this year.
Fed officials are watching to see how long those savings will continue to buoy spending. Americans are running up more credit card debt, a sign that their savings are running out. Bank of America has said that credit card balances for its upper- and middle-income clients remain below pre-pandemic levels but have grown sharply for lower-income groups.
Businesses, particularly large ones, also took advantage of lower rates in 2020 and 2021 to refinance debt, thereby locking in lower payments. As a result, rate hikes haven't necessarily raised their borrowing costs. Over time, according to a report from the Federal Reserve's Boston branch, much of that borrowing will have to be refinanced at higher rates. Profit growth could then suffer, and companies may lay off workers.
For now, some businesses are also benefiting from government subsidies in legislation pushed by the Biden administration, including measures to boost investment in infrastructure, renewable energy and semiconductor manufacturing. Spending on new factories has jumped in response.
“We’ve had a supply-side revival — driven, in part, by public investment,” said Daleep Singh, chief global economist at PGIM Fixed Income, and formerly a top economic official in the administration.
Last week, the Fed's policymakers revised their economic projections to show core inflation — excluding volatile food and energy — amounting to 2.6% by the end of next year, down from 4.2% now, according to the Fed's preferred measure. At the same time, they foresee unemployment edging up to just 4.1% — lower than their June forecast of 4.5% for 2024.
“If we actually get an outcome like that ... without a recession, that’s a really good outcome, given the scope of the shock,” said William English, a former senior Fed official who is now a professor at Yale School of Management.