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The Phillips curve is an economic model positing that an inverse relationship exists between unemployment and inflation. This inverse relationship provides several potential guidelines for central bank policy. One such guideline is that an equilibrium unemployment rate corresponds to a stable inflation rate, all else held equal. In “25 years of excess unemployment in advanced economies: lessons for monetary policy” (Peterson Institute for International Economics, Working Paper 22-17, October 2022), Joseph E. Gagnon and Madi Sarsenbayev argue that central banks in the world’s 11 most advanced economies have overestimated the equilibrium rate of unemployment for the past several decades. The authors find that estimates of the equilibrium unemployment rates in these countries are commonly incorrect because of the hypothesis that the Phillips curve is linear. Gagnon and Sarsenbayev argue that the Phillips curve is nonlinear because of downward wage and price rigidity. More specifically, wages tend not to decrease, even during economic contractions; prices are less rigid, but they also tend not to decrease, especially on average and over the long term. Wage and price rigidity causes the Phillips curve to flatten when the unemployment rate is above its equilibrium rate. The curve was steep and linear in the 1970s and 1980s, when inflation was high. Since the 1990s, however, with inflation averaging about 2 percent (before the pandemic), the Phillips curve has had a negative slope when unemployment rates are low (below the equilibrium rate) and a much flatter slope when unemployment rates are high. Accordingly, the Phillips curve is nonlinear over its range. The authors argue that if the Phillips curve is flat when the unemployment rate is above the equilibrium rate, then the equilibrium rate is difficult to estimate. A flat portion of the Phillips curve will contain different unemployment rates corresponding to the same inflation rate. For example, if the Phillips curve is flat above 2-percent unemployment, then the inflation rate will be near zero when the unemployment rate is above 2 percent. As such, there will not be a unique unemployment rate that corresponds to a close-to-zero inflation rate. Gagnon and Sarsenbayev argue that because central banks rely on a linear Phillips curve model, they overestimate the equilibrium rate of unemployment. As a result, many economies have higher levels of unemployment than are necessary for price stability. The authors provide empirical data to show that the unemployment rate was above the equilibrium rate in the 11 advanced economies for the past 25 years. They estimate that the “true unemployment gap,” the difference between the unemployment rate and its corresponding equilibrium rate, ranged from about –5 percent to nearly 20 percent for different nations. Gagnon and Sarsenbayev recommend that central banks allow the unemployment rate to move below the estimated equilibrium rate. The authors find that exploring lower unemployment rates is needed to discover the actual slopes of a nonlinear Phillips curve. In addition, allowing the unemployment rate to move lower may help central banks meet their inflation rate targets. Many of the 11 nations have an inflation rate that is commonly below target. Finally, Gagnon and Sarsenbayev find that the increase in inflation in 2021–22 was due to exogenous shocks (especially the recent pandemic). Thus, they argue that low inflation will likely reappear once these shocks abate.

Improving workers livelihoods as the Federal Reserve manages its dual mandate. As noted above, the Federal Reserve has a dual mandate—maximum employment and price stability. Through its use of monetary policy, the Federal Reserve plays a vital role in promoting full employment; however, monetary policy has proven insufficient for eliminating involuntary unemployment. Historically, the Federal Reserve has had a significant role in increasing unemployment as a result of combating any inflationary pressures that may exist in the economy. With a job guarantee policy in place, the Federal Reserve can conduct monetary policy without promoting rising levels of unemployment. In this scenario, the job guarantee program can maintain employment and consumption expenditures while the Federal Reserve employs monetary policy to reduce private investment in order to cool the economy. Thus, U.S. workers would be less vulnerable to the Federal Reserve not adhering to their responsibility of a dual mandate appropriately due to their cultural over-emphasis—a function of their close ties to the financial sector—on price stability.

Politics is largely the art of theatrics and illusions. Crises are manufactured to enable both parties to claim to be the firefighters who extinguished the fire. But the underlying problems remain unaddressed, guaranteeing a new crisis in a never-ending cycle. The recent debt ceiling deal, suspending the debt limit for two years, is emblematic. The crisis was created by government spending extravagance that had sent the national debt surging past $31 trillion and incurring carrying costs approaching $1 trillion even with record low interest rates. The Congressional Budget Office projects the national debt at a staggering $50 trillion by the end of the next decade. If interest rates on Treasury securities climb back to historical averages, that means the lion’s share of the federal budget will be devoted to paying the carrying costs of the debt, with crumbs left over for everything else, including defense, Social Security and Medicare. Our financial doomsday clock is approaching midnight. And the president and Congress, like the ostrich, stick their heads in the sand. In but 14 years, Social Security trust funds necessary to pay benefits are projected to become exhausted. The Medicare Hospital Insurance Fund is projected to be depleted by 2031. Annual trillion-dollar budget deficits are projected as far as the eye can see. National security spending is out of control, despite the elimination of any danger of foreign aggression against the United States. We are the safest country in the history of the world by orders of magnitude, yet we are spending more than $1.6 trillion annually and climbing in preparing to fight the last war — more than 50 percent of all discretionary spending. A national defense strategy of invincible self-defense could be sustained by a fraction of the current $1.6 trillion. The battlefield is moving to space and cyberspace. We now sport a Space Command. Cyber-attacks can easily cripple a nation’s infrastructure and military communications. Military technologies, including drone warfare, are changing at warp speed. Traditional weapons systems that gestate long years before coming to fruition are commonly obsolete before deployment. The F-35 Lightning II Joint Strike Fighter program is the Defense Department’s most expensive weapon system program. The Department estimates it will cost nearly $1.7 trillion to buy, operate and sustain the aircraft and systems over its lifetime. I would wager that the F-35 will never be used to defend the U.S. against foreign aggression. Entitlement programs must also be arrested or terminated in favor of a single national safety net for the truly destitute. In fiscal year 2022, entitlement programs gobbled up 52 percent of the budget. In the prior fiscal year, the number reached an astronomical 66 percent because of one-time Covid payments. There are six major entitlement programs based on various thresholds of need: Social Security, Medicare, Temporary Assistance for Needy Families, Medicaid, unemployment, and economic support. These entitlement programs should be phased out favor of a national safety net to ensure all have access to the bare necessities, comparable to President Richard Nixon’s Family Assistance Program. The goals should be to encourage self-improvement and self-reliance — the touchstones of self-esteem and pride. As the proverb goes, “If you give a man a fish, you feed him for a day. If you teach a man to fish, you feed him for a lifetime.” Now is no time for complacency. The nation’s fiscal crisis waxes daily. The population ages, thrusting a prohibitive financial burden on the new generation. In 1960, there were 5.1 workers per Social Security beneficiary; that ratio has dropped to 2.8 today. The Federal Reserve is insolvent. Its balance sheet of U.S. Treasury bonds and mortgage-backed securities jumped from $4 trillion when the Covid-19 pandemic began to $9 trillion at the start of 2022 as interest rates approached zero. With interest rates now climbing back to historical averages to fight inflation, these Treasury bonds and securities are worth but a fraction of their face value or cost. If the assets were carried at market value, the Fed would be insolvent. Many private banks have similarly vastly overvalued loans or securities because of the spike in interest rates. The bailouts of Silicon Valley Bank and First Republic Bank are but the tip of the iceberg. Herbert Stein was chairman of the Council of Economic Advisors under Presidents Nixon and Gerald R. Ford. He advised that, “If something cannot go on forever, it will stop.” We are about to witness the truth of that wisdom as the nation inches daily towards insolvency. Congress and the White House fiddle as the country capsizes.

The inflation surge of the past two years is a warning about what can happen when sudden changes in the things we want collide with massive disruptions in our ability to make them. While current inflation slowed to 4.9 percent in April according to Labor Department data released today, after more than a year of Fed interest rate hikes, it’s likely to fade eventually as the Covid-19 pandemic and its associated policy responses continue to normalize. But this victory may ultimately prove fleeting: compared to the relative stability we’ve come to take for granted over the last few decades, price changes in the decades ahead could be far more volatile, while underlying inflation could be faster and more persistent than in the recent past. That’s because we’re poised to endure at least two major social transformations this century that will reshape the economy — and heighten inflation risks. The first is the compounding effects of climate change, which will require massive investments in everything from sea walls to electric transmission lines to clean power generation. We’ll also need to find replacements for traditional plastic and discover greener ways to produce cement, steel, and meat economically. It’s a transition that, all together, will require trillions of dollars in new investment. And we will have to do all of this as worsening fires, droughts, and floods — along with climate-related migration flows — threaten to destabilize many societies and destroy productive capacity. This “green transition” is set to coincide with another unprecedented threat to social and economic stability: an aging and eventually shrinking population. By the end of the century, high-income countries and China, which together have consistently produced about 80 percent of the world’s economic output since at least 1960, are projected to lose more than 40 percent of their working-age populations — even as their elderly populations are poised to rise by roughly 60 percent. This “gray transition” will be extremely costly, requiring fewer people to work harder and longer to support a growing number of non-working retirees. Handled badly, either of these transitions alone would be enough to generate years of unwelcome price increases as businesses and consumers struggle to adapt to massive changes in the mix of goods and services we need, changes to the ways we produce, and impairments in our overall ability to produce anything. Together, they’re a recipe for prolonged and painful inflation.

Federal Reserve Chairman Jerome Powell has repeatedly said undercutting wage growth for American workers is essential for tamping down the worst bout of inflation in the U.S. in more than 40 years. But a raft of data suggest that robust corporate profit margins — not wages — are having a much bigger impact on rising prices, according to longtime Société Générale strategist Albert Edwards. Edwards calls this dynamic “greedflation”: the notion that corporate price gouging is helping to keep inflation robust at a time when commodity prices, which were initially blamed for the price shock, have actually fallen over the past 12 months. West Texas Intermediate crude oil CL00, -3.82% was trading at roughly $77 a barrel on Thursday, compared with $115 a barrel one year ago, according to FactSet data. Prices of other important industrial commodities, including copper, have also declined during the same period. In his latest note on the topic, shared with MarketWatch Thursday, Edwards questioned why the Fed has been so insistent on targeting wages instead of pointing the finger at corporations: “the primary driver of this inflation cycle is soaring profit margins. Rather than calling this out as the primary cause of high inflation, central banks have instead chosen to focus on rising nominal wages as threatening to embed higher inflation – the so called ‘wage/price spiral’.” Often, corporations are raising prices of goods and services not because they need to due to rising labor and raw materials costs, but because they can get away with it by blaming inflation, something that consumers have been primed by media reports to expect, Edwards said. Blaming wage growth for inflation seems particularly misguided considering that workers’ wages haven’t even kept pace with rising consumer prices, Edwards said. Meanwhile, corporate profit margins have climbed to near-record highs. Profits for non-financial companies rose to nearly $2.1 trillion in the third quarter, a record high on a nominal basis, according to Commerce Department data. They have risen sharply since the onset of the COVID-19 pandemic in March 2020. This isn’t the first time Edwards has explored this topic in his research shared with Societe Generale clients. He examined the issue of price gouging in a note published back in November. The chart below, which shows how corporate profits as a percentage of GDP have risen to record highs, is from that previous note. While workers’ earnings have generally increased, they haven’t kept pace with rising consumer prices, which means that, when adjusted for inflation, workers’ earning power has actually declined. Average hourly earnings increased by 4.6% year-over-year, according to the latest monthly jobs data released by the Department of Labor. That’s less than the headline year-over-year increase in the consumer-price index, which stood at 6%. Moreover, Edwards showed that U.S. workers’ earnings compared to the costs of the goods and services they help to produce had been declining for years, tracing the start of the trend to when China joined the World Trade Organization in December 2001. Using an example taken from Howard University economics professor William Spriggs, Edwards pointed out that if wages truly are the driving inflation, then the cost of food at restaurants should be rising faster than the cost of food consumed at home because of the cost of labor. But the opposite is true, according to the consumer-price index, a closely watched gauge of inflation produced by the U.S. government. The cost of food eaten at home has risen by 10.2% during the year through February, according to the latest CPI data from February. By comparison, the cost of food consumer away from home has increased by 8.4%. “If wage inflation was pushing prices higher, food at home would exceed food away from home,” Edwards said. Therefore, “wages are not the problem.”

The May employment report shows continued growth in the economy, with no deceleration. Wage inflation has slowed relative to its peak in 2022, but the latest monthly data show it continuing well in excess of reasonable goals. And the April consumer expenditures price index showed little progress in the last few months. The Federal Reserve’s monetary policy committee will meet June 13-14. Officials have been hinting that they may pause the Fed’s interest rate hikes, but they also have stressed that they will consider the latest information. “Looking ahead, we will take a data-dependent approach in determining the extent to which additional policy firming may be appropriate,” said Fed chair Jerome Powell after the May meeting. Some of the Fed decision-makers have wondered whether it’s time to wait, given the long time lags of monetary policy. Common econometric models show that monetary policy affects the economy with a time lag of about one year. They could be in a situation in which their past actions are about to take hold, and further action would go much too far. Time lag analysis is difficult. Historical data show varying magnitudes of effect, with varying time lags. Economists forecasting the economy often use judgmental adjustments to their models to reflect how they believe current conditions differ from the past conditions that generated the average effects and time lags. And although the one-year time lag is a good heuristic, the actual impact is distributed over time, with small effects early on, rising to a maximum effect, then dwindling to small effects much longer than a year later. The time lag for inflation effects is much longer, about two years from Fed action. The Fed now has to weigh the alternatives: risk overshooting because of those time lags, versus not doing enough in the first place. Here there is more consistency. Most Federal Reserve governors and presidents of the regional Federal Reserve banks have voiced support for their “risk management perspective.” They have looked at the cost of a too-easy monetary policy compared to a too-tight policy. Although they would like to make perfect policy, they have gained some humility in the wake of their early projections that inflation would be transitory. Economic history as well as accepted economic theory hold that inflation is much harder to fight when it has become firmly embedded in the expectations of consumers, workers and business decision-makers. So being too tight risks mild economic weakness, but being too loose could require a severe recession to break the inflation psychology. When the Fed is uncertain, they will tighten or at least keep interest rates high. Economists at the Fed have also worried about the impact of recent bank failures, including Silicon Valley Bank. Maybe banking industry distress will slow the economy so no further interest rate increases are necessary. The Fed’s survey of senior lending officers shows banks are tightening their credit standards. But looking at the survey over time shows recent changes are consistent with past eras of approaching economic weakness. That means we are not seeing anything unusual because of the bank failures. However, this survey is a fairly coarse measure. Weighing all of the evidence, the Fed is likely to continue its interest rate increases. If they do pause at the June meeting—not likely but certainly possible—then look for a rate hike in July.

The past month’s economic data has highlighted the persistent, sticky nature of inflation and the resilient strength of the labor market in the United States. Economists say that could mean more rate hikes from the Federal Reserve are coming, but investors appear sanguine. May saw payrolls increase by almost double the average monthly gain in the 10 years before the pandemic, while the Federal Reserve’s preferred inflation gauge bounced higher in April. Spending also remains strong. In this good-is-bad economy, strong employment and higher wages mean higher inflation as companies pass on increased labor costs by raising the price of goods. That makes it more difficult for the data-dependent Federal Reserve to justify a pause to interest rate hikes at its June meeting.

The Dow Jones nosedived this afternoon as the Federal Reserve – which has raised interest rates ten times since last year – held them steady for June but indicated that more hikes are on the way. A pause in the aggressive increases meant to stem inflation was expected, but hawkish commentary in a statement out of today’s Fed meeting wasn’t. A majority of governors are in favor of raising rates again this year and two more increases are expected. The Fed gave a target 5.6% terminal rate, or where it wants the number to settle. Chairman Jerome Powell just wrapped a press conference to take questions on the Fed’s thinking. The DJIA reversed course on the news, turning lower by nearly 400 points midafternoon. It’s off its lows. The Nasdaq and S&P 500 — both off by about half a percentage point on the announcement — also recovered somewhat but were jittery as Powell spoke. In its press release today, the Federal Open Market Committee said, “Recent indicators suggest that economic activity has continued to expand at a modest pace. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated.” Hikes are increasingly controversial, however, especially after some of the nation’s biggest bank failures ever this year starting in March and related to high interest rates. Also, annual inflation cooled in May to 4%, the slowest growth in more than two years, raising market hope the Fed might lay off interest rates beyond June. Still, core inflation is still double the Fed’s target of about 2%. Powell said July would be “a live meeting.” “We have to get it down to 2% and we will. But we just don’t see that yet,” Powell said at the presser, talking of inflation.

Federal Reserve officials are widely expected to announce on Wednesday a pause in their regimen of rate hikes. After 10 consecutive hikes, investors are pricing in a 94% chance that the Fed will leave rates unchanged for the first time since January 2022, according to the CME’s FedWatch Tool. But a pause is not a full stop. The labor market, which policymakers believe to be a key driver of inflation in the dominant services sector of the economy, is still remarkably strong. Now there’s a growing consensus on Wall Street that central bank officials could restart the hikes, meant to fight elevated inflation, as soon as July. But what does the Fed mean when it talks about labor markets and their impact on inflation? A lot of it has to do with a troublesome slowdown in productivity. At its most basic level, labor productivity is a measure of the value of the goods and services produced by a company compared with the amount of labor used to produce that output. Productivity moves in the opposite direction to wages and so if it remains depressed, there will be upward pressure on labor costs — and ultimately on inflation, said Lisa Shalett, CIO of Morgan Stanley Wealth Management. That’s a big deal to Fed officials who have spoken publicly about their fears of a wage-price spiral — the feedback loop that drives inflation higher as people make more money and go out and spend it. “The crosscurrents for the Fed are complex. Big bets about the pace of the hiking path are ill advised,” said Shalett. During the Fed policy meeting in May, participants expressed worry that even though the pace of wage growth has been gradually slowing, it is still “running at a pace that, given current estimates of trend productivity growth, was well above what would be consistent over the longer run with the Committee’s 2% inflation objective,” according to minutes from the meeting. Productivity in the United States has been steadily declining since 2005, but the post-pandemic landscape has accelerated that downturn significantly. Labor productivity decreased 2.1% in the first quarter of 2023, the US Bureau of Labor Statistics reported earlier this month. That was the worst reading since 2007, according to the BLS.

One of the remarkable things about the global economic order since World War II has been the flexibility of governments in responding to serious crises. From stagflation and the collapse of the Bretton Woods currency regime in the 1970s to the Asian financial crisis of the 1990s to the global financial crisis in this century, the world’s major economies have proven surprisingly adept at finding ways to cooperate to address serious challenges. This time around, that lucky streak may finally break. The current concatenation of problems—the Russia-Ukraine war, inflation, global food and energy shortages, unwinding asset bubbles in the United States, debt crises in developing countries, and the lingering impacts of COVID-19-related shutdowns and supply chain bottlenecks—may be the most serious crisis of them all, not least because central banks can’t print wheat and gasoline. Yet there are few signs of the collective responses that will be needed to meet these challenges. Global cooperation has never been more urgent—and seemed less likely. Fraying cooperation is, ironically, mostly a consequence of past successes. The world’s past ability to manage crises, transcend disruptions, and restore the trajectory of global growth means that many more countries today have become rich enough to wield influence and demand their interests be considered. Others are pursuing territorial or ideological goals they consider more urgent than immediate economic priorities. As a result, consensus has become almost impossible to find. The upshot is that in this crisis, the world will be condemned to a series of competing and partial responses rather than again finding a way to come together to address the challenge. The meeting of trade ministers at the World Trade Organization (WTO) in Geneva this week, originally scheduled for 2020 but postponed due to COVID-19, is a case in point. With 164 members and the rule that any agreement requires consensus among all of them, the WTO is handcuffed. Member states are still struggling, for example, to approve a waiver on patent rights for COVID-19 vaccines—already more than a year past the time it might have really helped. Similarly, they have been negotiating for more than two decades over curbing the subsidies that lead to destructive overfishing in the world’s oceans. Where the WTO once broke new ground to set trade rules and resolve disputes, it has played little role in addressing current supply chain challenges. Nor is it likely to respond effectively to the global food crisis as more than two dozen countries have already enacted export restrictions to preserve food supplies threatened by the collapse of Ukrainian and Russian grain exports. This week’s meeting in Geneva could even bring about tariff hikes by inaction: On Wednesday, a 1998 moratorium on tariffs for cross-border e-commerce—such as Apple downloads and Netflix streaming—automatically expires, and India and South Africa are blocking its renewal. No institution is indispensable, of course, and in the past, governments have found new and creative ways to cooperate when old institutions proved insufficiently adept. That was the case in the 1970s, when the world faced the closest analogy to today’s challenges. A perfect storm of runaway inflation, wars in Vietnam and the Middle East, an oil cartel that drove up global energy prices, the collapse of the gold-backed currency system under Bretton Woods, and the Watergate political scandal in the United States produced a period of global instability and weak growth. At first, governments were unable to cooperate sufficiently to address those challenges. A burgeoning literature emerged at the time on the “legitimation crisis” of Western capitalism. But the finance ministers of leading Western economies did come together to try to build a new monetary system after then-U.S. President Richard Nixon ended the gold convertibility of the dollar in 1971. These efforts led directly to the first G-6 summit meeting in France in 1975, where leaders of major industrialized nations tasked themselves with finding mutually reinforcing ways to revive their ailing economies. The group, which later became the G-7 (and later G-8 when it added Russia, only to drop it again following its 2014 annexation of Crimea), continues to provide a loose coordinating structure for the leading Western economies of today. More than two relatively uneventful decades later, the G-20 was born out of a series of destabilizing financial crises, including the 1994-1995 Mexican peso crisis, the 1997-1998 Asian financial crisis, and the 1998 Russian currency collapse. By that time, significant new economic powers had emerged, and the creation of the G-20 recognized that changing reality. The group includes China, India, Brazil, Russia, Mexico, and Indonesia, among others—broadening the rich nations’ club to one that was more representative of the 1990s economy. Like the G-7, the G-20 began as a regular meeting of finance ministers and was upgraded to an annual leaders’ summit during the 2008 global financial crisis. Amid the crisis and its aftermath, the G-20 became the focal point for global efforts to restore economic growth, helped jump-start the global economy through coordinated stimulus measures, worked to strengthen financial regulations, and expanded the lending capacity of the International Monetary Fund. To be sure, such cooperative efforts have rarely been transformational. Both the G-7 and the G-20 lack decision-making authority, serving more as an effort to nudge countries to undertake mutually supportive policies. The purpose of such organizations is often less about developing grand schemes for recovery and more about keeping matters from getting worse. One of the key accomplishments of the G-20 during the global financial crisis was to get strong pledges from member states to avoid protectionist responses, which would have worsened the global slowdown—pledges that were mostly met. Even such modest accomplishments are vastly better than countries working at cross-purposes or actively undermining one another’s economic interests. So if the WTO is handcuffed by consensus and if the G-7 and G-20 lack authority, what group or body might ride to the rescue this time? Merely asking the question shows how hard it will be to coordinate a global response to the current set of crises. The United States and its allies are actively working to damage Russia’s economy through the broadest sanctions ever levied, and Russia is responding by blocking shipments of Ukrainian grain through its Black Sea ports. This leaves the G-20 divided and powerless. U.S. Treasury Secretary Janet Yellen has called for Russia’s expulsion from the group and threatened to boycott meetings if Russia attends. Along with finance ministers and central bankers from several countries, she walked out of an April G-20 meeting in Washington when the Russian delegation was speaking. The meeting ended without the usual communique indicating areas of agreement. But removing Russia from the group is unlikely to happen; only Canada and Australia have formally joined the United States’ demand to do so. This year’s summit host, Indonesia, has already invited Russia to the planned November meeting (and issued a one-time invitation to Ukraine, which is not a member). Russia’s participation alone might be enough to neuter the G-20, but other members are also unlikely to get on board any strategy premised on strengthening the global economy while isolating Russia. China, in particular, has refused to break ties with Russia and is focused on greater self-sufficiency to protect its economy from the sort of sanctions levied against Russia by Western economies. These Western economies, through the G-7 and other fora, are more united than they have been in years, even if there are continued differences over how far to ratchet up sanctions against Russia. This is no small achievement: The G-7 economies still account for nearly half of the global economy and lead in the most sophisticated technologies. The United States and Europe have largely moved past disputes over trade in steel, aluminum, and aircraft that now look trivial in the current environment. But the scale of the current challenges is beyond what the G-7 countries can meet on their own. For example, the G-7 has developed a potentially robust plan, supported by more than 50 nations, for addressing food security issues by expanding financial and technical support in exchange for countries agreeing to forego export bans and other measures that would further distort global food markets. But India, which banned wheat exports last month, has so far blocked the initiative. New Delhi is also resisting other measures to free up food stocks for poorer nations to pursue greater self-sufficiency in agricultural production. The Biden administration has been creative in trying to find workarounds and build coalitions of like-minded countries. The U.S.-EU Trade and Technology Council has been coordinating responses on issues related to export controls, data sharing, and resilience in critical technologies. During his visit to Tokyo last month, U.S. President Joe Biden launched a new Indo-Pacific Economic Framework, which includes Japan, South Korea, and India. Although details are vague, the new forum is intended to promote cooperation on issues such as digital trade, decarbonization, and tax coordination. At last week’s Summit of the Americas in Los Angeles, the United States unveiled its Americas Partnership for Economic Prosperity with a similar agenda. But the meeting was not attended by Latin America’s second-largest economy after Brazil: Mexican President Andrés Manuel López Obrador boycotted the summit after the Biden administration excluded Cuba, Venezuela, and Nicaragua. Although admirably creative, none of these initiatives are remotely equal to the urgency of the moment. During previous crises, the world’s leading governments were able to set aside enough of their differences to come up with robust responses. This time around, that is nowhere in sight. This breakdown of cooperation may be the most lasting and worrisome effect of the current series of overlapping crises. So far, the disruptions have not significantly harmed global trade as a whole: Trade values hit record level in 2021, though they are slowing this year, and sectors like food and energy have been significantly disrupted. But the current crises have brought a hard stop to the confidence that, whatever their differences, the world’s leading economies are united on the importance of economic growth and stability and can work together to the greatest extent possible to achieve those goals. This time, there is no one steering the ship.

To call 2021 the summer of discontent would be a severe understatement. From Cuba to South Africa to Colombia to Haiti, often violent protests are sweeping every corner of the globe as angry citizens are taking to the streets. Each country has different histories and realities on the ground, particularly in Haiti, where years of violence and government corruption culminated two weeks ago in the assassination of President Jovenel Moïse. But they all faced a perfect storm of preexisting social, economic, and political hardships, which fallout from the COVID-19 pandemic only inflamed further. And they are merely a foreshadowing of the post-coronavirus global tinderbox that’s looming as existing tensions in countries across the world morph into broader civil unrest and uprisings against economic hardships and inequality deepened by the pandemic. The coronavirus pandemic was a once-in-a-century crisis that not only shocked countries’ existing health systems but also demanded a response that impacted—and was itself shaped by—economic, political, and security considerations. The efforts to contain it may have curbed fatalities in the short term but have inadvertently deepened vulnerabilities that laid the groundwork for longer-term violence, conflict, and political upheaval and should serve as a danger sign to world leaders as countries reopen—including in the United States. History is full of examples of pandemics being incubators of social unrest, from the Black Death to the Spanish flu to the great cholera outbreak in Paris, immortalized in Victor Hugo’s Les Miserables. Underlying it all this time around is a pervasive inequality. COVID-19 has ripped open economic divides and made life harder for already vulnerable groups, including women and girls and minority communities. It has also exposed weaknesses in food security and dramatically increased the number of people affected by chronic hunger. The United Nations estimates around one-tenth of the global population—between 720 million people and 811 million—were undernourished last year. The impacts of climate change and environmental degradation have only compounded the despair. Take the Sahel, where, due to a toxic cocktail of conflict, COVID-19 lockdowns, and climate change, the scale and severity of food insecurity continues to rise. Countries such as Ethiopia and Sudan are among the world’s worst humanitarian crises, with catastrophic levels of hunger. Droughts and locusts are coming at a critical time for farmers ready to plant crops and are stopping herders in their tracks from driving their livestock to greener pastures. The global vaccine shortage is fueling the instability. A majority of Africa is lagging far behind the world in vaccinations, meaning COVID-19 will continue to constrain national economies and, in turn, become a source of potential political instability. The same is true for much of Latin America and Asia, where countries don’t have enough vaccines to protect their populations and simmering sources of protest—such as rising living costs and deepening inequalities—are more likely to boil over. The global risk firm Verisk Maplecroft has warned that as many as 37 countries could face large protest movements for up to three years. A new study by Mercy Corps examining the intersection of COVID-19 and conflict found concerning trends that warn of potential for new conflict, deepening existing conflict, and worsening insecurity and instability shaped by the pandemic response. The group found a collapse of public confidence in governments and institutions was a key driver of instability. People in fragile states, already suffering from diminished trust in their government, have felt further abandoned as they face disruptions in public services, rising food prices, and massive economic hardships, such as unemployment and reduced wages. Supply chains disrupted during the pandemic have seen food prices skyrocket, while in the global recession humanitarian aid budgets are being slashed, bringing many countries to the brink of famine. For the first time in 22 years, extreme poverty—people living on less than $1.90 a day—was on the rise last year. Oxfam International estimates that “it could take more than a decade for the world’s poorest to recover from the economic impacts of the pandemic.” The shocks caused by the pandemic have also eroded social cohesion, further fraying relations between communities and deepening polarization. That is especially true in the United States, where social and political pressures both deepened the health crisis and were themselves worsened by it. All of this should serve as a clarion call to countries that they can’t prepare for, or respond to, future health crises in a vacuum—but must anticipate an economic, political, and social crisis. This is true for any severe shock, which brings the potential for a breakdown in public order.

A large portion of the burden of creating and maintaining order at the regional or global level will fall on the United States. This is inevitable for several reasons, only one of which is that the United States is and will likely remain the most powerful country in the world for decades to come. The corollary to this point is that no other country or group of countries has either the capacity or the mind-set to build a global order. Nor can order ever be expected to emerge automatically; there is no invisible hand in the geopolitical marketplace. Again, a large part of the burden (or, more positively, opportunity) falls on the principal power of the day. There is more than a little self-interest at stake. The United States cannot remain aloof, much less unaffected by a world in disarray. Globalization is more reality than choice. At the regional level, the United States actually faces the opposite problem, namely, that certain actors do have the mind-set and means to shape an order. The problem is that their views of order are in part or in whole incompatible with U.S. interests. Examples would include Iran and ISIS in the Middle East, China in Asia, and Russia in Europe. It will not be an easy time for the United States. The sheer number and range of challenges is daunting. There are a large number of actors and forces to contend with. Alliances, normally created in opposition to some country or countries, may not be as useful a vehicle in a world in which not all foes are always foes and not all friends are always friendly. Diplomacy will count for a great deal; there will be a premium on dexterity. Consultations that aim to affect the actions of other governments and their leaders are likely to matter more than negotiations that aim to solve problems. Another reality is that the United States for all its power cannot impose order. Partially this reflects what might be called structural realities, namely, that no country can contend with global challenges on its own given the very nature of these challenges. The United States could reduce its carbon footprint dramatically, but the effect on global climate would be modest if India and China failed to follow suit. Similarly, on its own the United States cannot maintain a world trading system or successfully combat terrorism or disease. Adding to these realities are resource limits. The United States cannot provide all the troops or dollars to maintain order in the Middle East and Europe and Asia and South Asia. There is simply too much capability in too many hands. Unilateralism is rarely a serious foreign policy option. Partners are essential. That is one of the reasons why sovereign obligation is a desirable compass for U.S. foreign policy. Earlier I made the case that it represents realism for an era of globalization. It also is a natural successor to containment, the doctrine that guided the United States for the four decades of the Cold War. There are basic differences, however. Containment was about holding back more than bringing in and was designed for an era when rivals were almost always adversaries and in which the challenges were mostly related to classical geopolitical competition.1 Sovereign obligation, by contrast, is designed for a world in which sometime rivals are sometime partners and in which collective efforts are required to meet common challenges. Up to this point, we have focused on what the United States needs to do in the world to promote order. That is what one would expect from a book about international relations and American foreign policy. But a focus on foreign policy is not enough. National security is a coin with two sides, and what the United States does at home, what is normally thought of as belonging to the domestic realm, is every bit as much a part of national security as foreign policy. It is best to understand the issue as guns and butter rather than guns versus butter. When it comes to the domestic side, the argument is straightforward. In order to lead and compete and act effectively in the world, the United States needs to put its house in order. I have written on what this entails in a book titled Foreign Policy Begins at Home.2 This was sometimes interpreted as suggesting a turn away from foreign policy. It was nothing of the sort. Foreign policy begins at home, but it ends there only at the country’s peril.3 Earlier I mentioned that the United States has few unilateral options, that there are few if any things it can do better alone than with others. The counterpart to this claim is that the world cannot come up with the elements of a working order absent the United States. The United States is not sufficient, but it is necessary. It is also true that the United States cannot lead or act effectively in the world if it does not have a strong domestic foundation. National security inevitably requires significant amounts of human, physical, and financial resources to draw on. The better the United States is doing economically, the more it will have available in the way of resources to devote to what it wants and needs to do abroad without igniting a divisive and distracting domestic debate as to priorities. An additional benefit is that respect for the United States and for the American political, social, and economic model (along with a desire to emulate it) will increase only if it is seen as successful. The most basic test of the success of the model will be economic growth. U.S. growth levels may appear all right when compared with what a good many other countries are experiencing, but they are below what is needed and fall short of what is possible. There is no reason why the United States is not growing in the range of 3 percent or even higher other than what it is doing and, more important, not doing.4

Several recent works on China and Sino–US relations have made substantial contributions to the current understanding of how and under what circumstances a combination of nuclear deterrence and economic interdependence may reduce the risk of war between major powers. At least four conclusions can be drawn from the review above: first, those who say that interdependence may both inhibit and drive conflict are right. Interdependence raises the cost of conflict for all sides but asymmetrical or unbalanced dependencies and negative trade expectations may generate tensions leading to trade wars among interdependent states that in turn increase the risk of military conflict (Copeland, 2015: 1, 14, 437; Roach, 2014). The risk may increase if one of the interdependent countries is governed by an inward-looking socio-economic coalition (Solingen, 2015); second, the risk of war between China and the US should not just be analysed bilaterally but include their allies and partners. Third party countries could drag China or the US into confrontation; third, in this context it is of some comfort that the three main economic powers in Northeast Asia (China, Japan and South Korea) are all deeply integrated economically through production networks within a global system of trade and finance (Ravenhill, 2014; Yoshimatsu, 2014: 576); and fourth, decisions for war and peace are taken by very few people, who act on the basis of their future expectations. International relations theory must be supplemented by foreign policy analysis in order to assess the value attributed by national decision-makers to economic development and their assessments of risks and opportunities. If leaders on either side of the Atlantic begin to seriously fear or anticipate their own nation’s decline then they may blame this on external dependence, appeal to anti-foreign sentiments, contemplate the use of force to gain respect or credibility, adopt protectionist policies, and ultimately refuse to be deterred by either nuclear arms or prospects of socioeconomic calamities. Such a dangerous shift could happen abruptly, i.e. under the instigation of actions by a third party – or against a third party. Yet as long as there is both nuclear deterrence and interdependence, the tensions in East Asia are unlikely to escalate to war. As Chan (2013) says, all states in the region are aware that they cannot count on support from either China or the US if they make provocative moves. The greatest risk is not that a territorial dispute leads to war under present circumstances but that changes in the world economy alter those circumstances in ways that render inter-state peace more precarious. If China and the US fail to rebalance their financial and trading relations (Roach, 2014) then a trade war could result, interrupting transnational production networks, provoking social distress, and exacerbating nationalist emotions. This could have unforeseen consequences in the field of security, with nuclear deterrence remaining the only factor to protect the world from Armageddon, and unreliably so. Deterrence could lose its credibility: one of the two great powers might gamble that the other yield in a cyber-war or conventional limited war, or third party countries might engage in conflict with each other, with a view to obliging Washington or Beijing to intervene.

The next economic crisis is closer than you think. But what you should really worry about is what comes after: in the current social, political, and technological landscape, a prolonged economic crisis, combined with rising income inequality, could well escalate into a major global military conflict. The 2008-09 global financial crisis almost bankrupted governments and caused systemic collapse. Policymakers managed to pull the global economy back from the brink, using massive monetary stimulus, including quantitative easing and near-zero (or even negative) interest rates. But monetary stimulus is like an adrenaline shot to jump-start an arrested heart; it can revive the patient, but it does nothing to cure the disease. Treating a sick economy requires structural reforms, which can cover everything from financial and labour markets to tax systems, fertility patterns, and education policies. Policymakers have utterly failed to pursue such reforms, despite promising to do so. Instead, they have remained preoccupied with politics. From Italy to Germany, forming and sustaining governments now seems to take more time than actual governing. Greece, for example, has relied on money from international creditors to keep its head (barely) above water, rather than genuinely reforming its pension system or improving its business environment. The lack of structural reform has meant that the unprecedented excess liquidity that central banks injected into their economies was not allocated to its most efficient uses. Instead, it raised global asset prices to levels even higher than those prevailing before 2008. In the United States, housing prices are now 8% higher than they were at the peak of the property bubble in 2006, according to the property website Zillow. The price-to-earnings (CAPE) ratio, which measures whether stock-market prices are within a reasonable range, is now higher than it was both in 2008 and at the start of the Great Depression in 1929. As monetary tightening reveals the vulnerabilities in the real economy, the collapse of asset-price bubbles will trigger another economic crisis – one that could be even more severe than the last, because we have built up a tolerance to our strongest macroeconomic medications. A decade of regular adrenaline shots, in the form of ultra-low interest rates and unconventional monetary policies, has severely depleted their power to stabilise and stimulate the economy. If history is any guide, the consequences of this mistake could extend far beyond the economy. According to Harvard’s Benjamin Friedman, prolonged periods of economic distress have been characterised also by public antipathy toward minority groups or foreign countries – attitudes that can help to fuel unrest, terrorism, or even war. For example, during the Great Depression, US President Herbert Hoover signed the 1930 Smoot-Hawley Tariff Act, intended to protect American workers and farmers from foreign competition. In the subsequent five years, global trade shrank by two-thirds. Within a decade, World War II had begun. To be sure, WWII, like World War I, was caused by a multitude of factors; there is no standard path to war. But there is reason to believe that high levels of inequality can play a significant role in stoking conflict. According to research by the economist Thomas Piketty, a spike in income inequality is often followed by a great crisis. Income inequality then declines for a while, before rising again, until a new peak – and a new disaster. Though causality has yet to be proven, given the limited number of data points, this correlation should not be taken lightly, especially with wealth and income inequality at historically high levels. This is all the more worrying in view of the numerous other factors stoking social unrest and diplomatic tension, including technological disruption, a record-breaking migration crisis, anxiety over globalisation, political polarisation, and rising nationalism. All are symptoms of failed policies that could turn out to be trigger points for a future crisis. Voters have good reason to be frustrated, but the emotionally appealing populists to whom they are increasingly giving their support are offering ill-advised solutions that will only make matters worse. For example, despite the world’s unprecedented interconnectedness, multilateralism is increasingly being eschewed, as countries – most notably, Donald J. Trump’s US – pursue unilateral, isolationist policies. Meanwhile, proxy wars are raging in Syria and Yemen. Against this background, we must take seriously the possibility that the next economic crisis could lead to a large-scale military confrontation. By the logic of the political scientist Samuel Huntington, considering such a scenario could help us avoid it because it would force us to take action. In this case, the key will be for policymakers to pursue the structural reforms that they have long promised while replacing finger-pointing and antagonism with a sensible and respectful global dialogue. The alternative may well be global conflagration.

Policymakers have great power over the economy, at least in the short term. A famous study by David and Christina Romer studied Federal Reserve minutes to identify episodes in which the Fed deliberately sought to slam on the economic brakes or step on the accelerator. They found that what the Fed wants, the Fed gets. But power isn’t the same as precision. The Fed normally tries to manage the economy by setting targets for short-term interest rates, which it has no trouble achieving. But suppose the Fed raises its interest rate target by one percentage point. This will surely, other things equal, lead to fewer job openings, lower inflation and probably a rise in unemployment. But how big will these effects be? Nobody is really sure. Fed officials, I’m sure you’ll be reassured to hear, know what they don’t know. That’s why they constantly say that their policy is “data-dependent” — they’ll adjust their actions based on what they see happening. But keeping a close eye on the data isn’t as helpful as it might seem. For one thing, much economic data lags months behind the actual state of the economy and is subject to frequent revisions. Even more important, changes in policy don’t have immediate, visible effects. Think about one of the main ways Fed policy affects the economy: via housing construction. A hike in the interest rates the Fed controls may not immediately filter through into a rise in mortgage rates; higher mortgage rates take time to show up in reduced housing starts and even longer to show up in a decline in the number of homes under construction; and the effects of reduced construction on things like retail sales add yet another lag. Because of all these lags, policy that is too data-dependent — that reacts strongly to the latest numbers — can end up being destabilizing. Milton Friedman is said to have used the metaphor of “the fool in the shower,” who is alternately frozen and scalded because he’s constantly adjusting the taps in response to the current water temperature. So where are we now? The Fed began raising rates in March 2022; almost every economist I listen to agrees that it was right to do so. But the job market still looks strong, and inflation is still above target. Does this mean that the Fed hasn’t done enough? Maybe. But it’s also possible that the Fed has already done too much but we haven’t yet seen the effects of past rate hikes. I know perfectly reasonable, well-informed economists holding both views. Here’s where the metaphor of the soft landing actually works pretty well. Imagine a plane that is physically capable of making a smooth descent and touching down gently. But the pilot is trying to navigate through heavy fog with minimal visibility, and the instrument panel gives only an unreliable estimate of the plane’s altitude five minutes ago. Obviously it’s easy to see how the plane might either make a crash landing (i.e., experience a recession) or overshoot the runway entirely (suffer persistent inflation). So can we manage a soft landing? Between the possibility that inflation will be sticky and hence hard to bring down, and the difficulty policymakers will inevitably face in sticking the landing, it’s hard to give us better than even odds of pulling it off. But maybe we should step back and take the larger view. Covid-19 was an enormous shock to the economic system, made worse by Russia’s invasion of Ukraine. Yet we made it through the pandemic recession with remarkably little widespread hardship — in the fall of 2021, according to a Federal Reserve survey, 78 percent of Americans reported that their financial situation was at least OK, the highest percentage since the survey began in 2013. (We don’t yet have results for 2022.) That’s a huge success story and will remain a success story even if our landing is bumpier than we’d like. The job market is so strong that even if we have a temporary rise in unemployment, it won’t create that much hardship. Inflation is above target but nonetheless at a level Americans found quite tolerable in the past, so if it persists longer than the Fed would like, that won’t be a disaster. Unless we have a really, really hard landing, the overall story of the postpandemic economy will be one of remarkable resilience.

This paper revisits one of the fundamental questions of macroeconomics: Does monetary policy matter? It is a question that lies at the heart of any model of short-run macroeconomic fluctuations. If monetary policy matters, then it is vital to include a channel through which changes in aggregate demand have real effects. It is also a question that is once again at the forefront of policy discussions. The Federal Reserve is in the middle of an aggressive tightening, in hopes of lowering inflation. There appear to be widely disparate views about the likely effects of its actions on real activity, and about how quickly inflation might fall. “Does monetary policy matter?” is also a question that is inherently hard to answer. Like so many empirical questions in economics, omitted variable bias is a central issue. Both monetary policy actions and real economic activity are likely to be influenced by other variables. Anything that affects output—expectations, fiscal policy, financial stress—is also likely to drive decisions by the Federal Reserve. As Kareken and Solow (1963) pointed out long ago, in the extreme case where monetary policymakers use policy to successfully counteract other forces affecting output, one would find monetary policy variables moving all around and output not changing. A simple regression of output on an indicator of monetary policy would naively and incorrectly conclude that monetary policy didn’t matter. That is, if countercyclical monetary policy actions are common, the estimated impact of monetary policy will be biased toward zero. In 1989, we wrote a paper on the effects of monetary policy using a technique we termed the “narrative approach” (Romer and Romer 1989). This is an empirical technique where one gathers systematic evidence from contemporaneous qualitative sources (such as newspapers, government reports, and policy meeting transcripts), and incorporates it into statistical analysis. In the case of our 1989 study, the idea was to deal with omitted variable bias by using the plentiful narrative record on the motivation for monetary policy actions. We used the records of the Federal Reserve to identify a subset of monetary actions that were not motivated by other factors affecting output. We argued that the behavior of output following these shocks would provide relatively unbiased estimates of the impact of monetary policy. The subtitle of that paper, “A New Test in the Spirit of Friedman and Schwartz,” captured our intellectual debt to Milton Friedman and Anna Jacobson Schwartz. Friedman and Schwartz pioneered the narrative approach in their seminal work, A Monetary History of the United States (1963). We like to think that we have built on their insights and added some modern rigor to the approach. Over our careers, we have used the narrative approach in a number of studies. For example, we used it to separate tax changes into those taken for countercyclical reasons or because spending was increasing, and those taken for more exogenous reasons (Romer and Romer 2010). We found that the estimated response of output to tax changes was faster and larger when we limited the analysis to exogenous changes. Others have also used the narrative approach to achieve macroeconomic identification. James Hamilton used it to argue that many large oil price increases resulted from factors outside the U.S. macroeconomy (Hamilton 1985). This suggested that the correlation he found between oil price shocks and recessions reflected a largely causal relationship (Hamilton 1983). Valerie Ramey used narrative sources to identify when news of changes in defense spending became known (Ramey 2011). This information allowed her to better estimate the size and timing of the effects of government spending. Andrew Jalil used the narrative approach to identify prewar financial crises in the United States, and to isolate a subset that were due to factors uncorrelated with macroeconomic conditions—such as managerial malfeasance or other idiosyncratic shocks (Jalil 2015). Incorporating this additional information allowed him to identify the true causal impact of financial crises. This address is an opportunity to reflect on the narrative approach, and to revisit our first paper using it. The heart of the address involves redoing our 1989 study. We feel we have learned a great deal about the pitfalls of narrative research and how to do it better over the past three-plus decades. In Section I, we discuss those lessons, and apply them to the identification of monetary policy shocks in the United States since 1946. Having redone the narrative work, we then incorporate the new evidence into a statistical framework. In Section II, we discuss both our methodology and our findings about the impact of monetary policy on real economic indicators, such as the unemployment rate and real GDP. We find that a contractionary monetary policy shock increases the unemployment rate by 1.6 percentage points and reduces real GDP by 4.4 percent, relative to the no-shock baseline. The effects of monetary policy are highly statistically significant. We find that our improved series on monetary policy shocks results in slightly smaller estimates of the real effects than we found in our 1989 study, but greater statistical precision. We also examine the impact of monetary shocks on inflation. We find that contractionary monetary policy reduces inflation by about 1.5 percentage points, but the effects develop slowly and are less precisely estimated than those for real activity.

Engineering a soft landing is hard. But if you zoom out from the strictest definition of the term, the U.S. Federal Reserve has managed it more often than is generally believed. Admittedly, by the textbook definition of raising interest rates to cool an overheating economy or inflation without triggering a recession, the Fed has only achieved that once in its history. That was in the mid-1990s, when the U.S. economy avoided recession after the Alan Greenspan Fed doubled interest rates to 6% between February 1994 and February 1995. The latest U.S. inflation and job market data this week sparked a tangible burst of optimism that the Fed, under the stewardship of Jerome Powell, might emulate that rare feat. To be fair to the Fed, it probably is more art than science, with luck playing a bigger part than skill. What Milton Friedman called the "long and variable lags" between monetary policy decisions and their effects on the economy can be anywhere from six months to two years. That's a big window. In a paper earlier this year, former Fed Vice Chair Alan Blinder - who was in situ during that fabled 1994-95 soft landing - said that it is "difficult, maybe impossible" to predict the timing of policy changes on the real economy. Blinder posits that the soft landing parameters of avoiding recession completely are too narrow. He argues that if GDP declines by less than 1% or there is no recession determined by the National Bureau of Economic Research for at least a year after a Fed tightening cycle, that is a "softish" landing. By this definition, Blinder reckons that five of the 11 Fed tightening cycles since 1965 were followed by soft landings to varying degrees, and the 1990-91 recession was due to Saddam Hussein and Iraq's invasion of Kuwait, not Alan Greenspan. Of the five hard landings, two were not a result of Fed monetary policy: the Great Recession of 2008-09 was because the financial system imploded, and the 2020 recession was a consequence of the global COVID-19 pandemic. That leaves three recessions - 1973-75, 1980 and 1981-82 - that can fairly be considered hard landings and a direct result of high interest rates. It's no coincidence that they followed what were by far the three most aggressive tightening cycles. As Blinder says, the landing largely depends on how high the 'plane' is flying before it starts its descent. To extend the analogy further, Powell and his colleagues are flying blind now, given the fog created by post-COVID pandemic supply chain disruptions, and food and energy shocks. "To achieve another soft landing under these circumstances, the Fed will have to be skillful indeed," Blinder concludes. Paul McCulley, adjunct professor at Georgetown University and former chief economist at bond giant Pimco, reckons the Fed is at the end of its cycle even though inflation remains well above the central bank's 2% target. He draws parallels with the end of the 1994-95 hiking cycle, particularly Greenspan's remarks in February 1995 that the Fed could keep rates on hold or even cut them, "despite adverse price data", if there were signs that underlying inflation pressures were cooling. The Fed cut rates five months later and the rest is soft landing history. "Knowing when to declare enough is enough is critical, to abort a self-feeding dynamic of negative macro animal spirits," McCulley said. In a paper last year analyzing 70 tightening cycles between 1980 and 2019 across 19 advanced and six emerging economies, the Bank for International Settlements used even looser definitions for hard and soft landings. A hard landing is a recession - two consecutive quarters of negative GDP growth - within three years of the interest rate peak; otherwise, it is a soft landing, the BIS wrote. The tightening cycles were defined as at least three consecutive quarters, ending with the policy rate at its peak. Of these 70 episodes, 41 ended with a hard landing and 29 with a soft landing. All else equal, larger rate hikes spread over a longer period are more likely to be associated with hard landings, and front-loaded tightening cycles tend to be followed more frequently by soft landings, the BIS found. Maybe the Fed does have a fighting chance this time around.

Until now, Federal Reserve chair Jerome Powell has effectively corralled his colleagues to show a united front at key turning points for monetary policy. However, his job has just got a lot more complicated. The Fed raised short-term interest rates by a quarter of a point on Wednesday in what was hoped to be the final rate hike of this cycle. That pushed the benchmark Fed funds target to a 5 to 5.25 per cent range. The economy slowed, but inflation accelerated in the first quarter. The Fed’s preferred measure of inflation – the core personal consumption expenditures price index – jumped to a 4.9 per cent annualised pace in the quarter, the hottest in a year. That is the wrong direction and will no doubt spur debate about whether the Fed can signal a definitive end to rate rises after this week’s meeting. The US central bank sees fighting inflation as a marathon, not a sprint. History is littered with central banks that gave up before they crossed the finish line. The result was a more corrosive bout of inflation or worse: stagflation. The Fed hoped to keep credit conditions tightening even after it paused on hikes. Inflation-adjusted rates were expected to rise as inflation cooled. The inflation data for the first-quarter suggests that inflation has become sticky, which could challenge that strategy. Further complicating matters is the tightening of credit due to recent financial market turmoil. No one knows exactly how much more credit conditions will tighten. Estimates range from what would equate to 0.5 to 1.5 percentage points in short-term rate rises. That is before increasing problems in the office market, which could add insult to injury. Office leases are resetting, and vacancies are rising. That will keep banks, which account for a disproportionate amount of commercial real estate loans, on the defensive. The Fed’s Senior Loan Officer Survey for the first quarter is due out on May 8. The leadership will have a sense of the direction of those results but not the full report; we are still flying blind on the tightening in the pipeline. The same survey revealed in January that 45 per cent of banks were already tightening lending standards for commercial and industrial loans; 69 per cent of loans for construction and land development were constrained. Companies with fewer than 250 employees, which are the backbone of the labour market, are especially vulnerable to those shifts. Those firms accounted for a record-breaking 70.9 per cent of job openings at the end of January, but have since lost steam. Job openings among the smallest businesses – less than 10 employees – plummeted in March, while layoffs and separations surged to their highest pace since the onset of the pandemic. Those concerns have begun to divide the Fed. The staff adopted a “mild recession” as their baseline scenario in March, while the leadership laid out a rise in unemployment that is consistent with a recession. Some had even voiced views that a pause instead of a rise in May would be prudent, given the need to assess the impact of tightening already under way. Such tightening could do much of the heavy lifting for the Fed when it comes to cooling the economy. Chicago Fed president Austan Goolsbee has led the pack in raising concerns and was one to watch to see if he dissented on those grounds at this week’s meeting. Dissents are rarely made in a vacuum; one usually represents two or more. This is before the Fed hits its hardest mile, when unemployment rises and the backlash to crossing the finish line on inflation intensifies. The fact that we are on the eve of an election year will only intensify those emotions; politicians will be eager to find a scapegoat. Most forget that even former Fed chairman Paul Volcker, who was practically canonised for his steely resolve against inflation, blinked when the going got tough. He reversed course and cut rates in mid-1980, an election year. The cuts didn’t last long; within less than six months rates skyrocketed from a low of 9 to 19 per cent. That pushed the economy into its second recession in less than a year. Powell has been attempting to avert such an outcome by trading some pain today to avoid higher inflation and a deeper recession down the road. That is great in theory, but hard to execute. Even “mild recessions”, such as the ones we saw in 1990-91 and 2001, proved difficult to escape. I have heard people use the term “garden variety recession” when discussing what may occur, as if job losses are like a stroll in the park. They are not. Divisions within the Fed are likely to deepen as the economy slows. I would like to believe that a soft landing is still possible. The only time the Fed actually achieved that outcome was in 1994, when officials were pre-empting what turned out to be nascent inflation. This time inflation is real.

The IMF has warned of a “hard landing” for the global economy if persistently troublesome inflation keeps interest rates higher for longer and amplifies financial risks. Although the fund left its overall economic forecasts largely unchanged from January in its latest World Economic Outlook, published on Tuesday, it stressed that signs of resilience alongside lower global energy and food prices masked a darker reality. Pierre-Olivier Gourinchas, the IMF’s chief economist, said: “Below the surface . . . turbulence is building, and the situation is quite fragile.” “Inflation is much stickier than anticipated even a few months ago,” he said. “More worrisome is that the sharp [monetary] policy tightening of the past 12 months is starting to have serious side effects for the financial sector.” In its twice-yearly full forecasts published on Tuesday, the IMF said the turmoil in the UK government bond market last autumn and the US banking turbulence last month showed the “significant vulnerabilities [that] exist both among banks and non-bank financial institutions”. “Risks to the outlook are heavily skewed to the downside, with the chances of a hard landing having risen sharply,” the IMF said. Gourinchas told the Financial Times that, while the banking system was far more resilient than during the 2008 financial crisis, policymakers had to “think about what could go wrong”. “We can all remember the long time between the failure of an individual institution, whether it was Bear Stearns or Countrywide,” he said, referring to institutions that failed more than a decade ago. “Every time, this was treated like an isolated incident, until it wasn’t.” The IMF’s new forecasts showed a 25 per cent chance that the annual global growth rate could fall below 2 per cent in 2023, a risk twice as large as normal. The global economy has only grown that slowly in five calendar years since 1970. If a significant financial shock hit — something the IMF attached 15 per cent risk to — the fund said global growth was likely to fall below the rate of population growth and result in a global recession. In the IMF’s unchanged central forecast, the global economy is expected to grow 2.8 per cent in 2023, rising to 3 per cent in 2024 and sticking at about that level until around 2028. IMF managing director Kristalina Georgieva last week said this was the weakest medium-term outlook for the global economy since 1990. Gourinchas told the FT the fund was projecting “supercharged” growth in China with other countries reverting to a more normal rate. The IMF also assumes that global productivity will deteriorate while economies will suffer from coronavirus pandemic “scarring”, and fragmentation amid geopolitical tensions. The US economic forecast has been raised versus the January forecast, and the fund is now expecting growth of 1.6 per cent in 2023 and 1.1 per cent in 2024. Three months ago, the IMF was projecting a 1.4 per cent increase this year followed by a 1 per cent expansion the following year. The eurozone is expected to grow more slowly at 0.8 per cent this year as member states deal with last year’s energy price increases before recovering to a 1.4 per cent rate in 2024. China’s forecast growth rate of 5.2 per cent in 2023 from the IMF is in line with the Beijing government’s target, although the fund expects it to slow to 4.5 per cent in 2024. The IMF called on central banks to keep working to bring inflation down and for governments to help by removing some of the fiscal support offered in recent years to deal with Covid-19 and the energy crisis. So long as financial markets remained relatively stable, central banks should do everything they can to beat inflation, the fund said. Gourinchas warned that price pressures could continue to prove more persistent, which would result in a “harder landing scenario”. “There is a concern out there that we may not have enough tightening in the system at this point and more will be needed,” he said. “That would certainly increase the odds that output would come down further compared to our projections.” However, a credit crunch, which some economists are predicting in the wake of last month’s US banking turmoil, could act as a disinflationary force, he said. “As long as it is orderly, some of this lending contraction may actually be beneficial in terms of bringing down inflation and may substitute for further interest rate hikes.” Janet Yellen, the US Treasury secretary, was more upbeat about the outlook, seeking to ease fears of a “hard landing”. She said she had not seen “evidence at this stage suggesting a contraction in credit” after the banking sector turmoil, and noted the US economy was still “performing exceptionally well”, with “continued solid job creation, inflation gradually moving down [and] robust consumer spending”. “I wouldn’t overdo the negativism about the global economy,” Yellen said told reporters. “I think the outlook is reasonably bright.”

Drawing upon recent household survey data, we show that high inflation is disproportionately hurting low-income households, including Black and Hispanic households and renters. It is noteworthy that the survey results do not support the recent suggestion of Nobel laureate economist Paul Krugman that low-income families “have actually been hurt less by inflation than families with higher incomes” because the wages of low-income households rose faster. People experience different inflation rates and different levels of inflation stress based on household composition and income, housing tenure and other factors. The Census Bureau’s Household Pulse Survey asked people how inflation has affected them. The Census Bureau launched the periodic survey in April 2020 to quickly gather information on key economic indicators—employment, food, housing and child care—during the pandemic. More than 154,000 people responded to questionnaires in the periods ended Sept. 28, Oct. 17 and Nov. 14, 2022 (waves 49 to 51). Nearly all respondents, 97 percent, reported that prices were increasing, and almost half of those individuals—47 percent—felt very stressed by inflation (Chart 2). More than 60 percent were very concerned about future, short-term inflation. We explore the impact of high inflation on different groups by tabulating the incidence of high inflation stress by level of household income, race and ethnicity, housing tenure and other dimensions. Since these factors are correlated—lower-income households are also more likely to rent, for example—we also present logit model estimates (a way to consider the probability of an event given the relationships of explanatory variables). Specifically, these estimates consider the incidence of high inflation stress given respondents’ income, race and ethnicity, housing tenure and other factors. The resulting “marginal effects” of income, for example, provide an estimate of how the incidence of high inflation stress varies as income changes, holding factors such as household size, housing tenure, and race and ethnicity constant. Prior research suggests that inflation hits low-income households hardest for several reasons. They spend more of their income on necessities such as food, gas and rent—categories with greater-than-average inflation rates—leaving few ways to reduce spending. When prices rise, middle-income households may react by consuming cheaper goods and buying more generic brands. Low-income households do not have the same flexibility; in many cases, they are already consuming the cheapest products. Additionally, many low-income households lack the ability of higher-income households to stock up when prices are discounted, buy in bulk and save, delay purchases if there is an opportunity to save in the future or buy more cheaply online. Low-income households are also likely to have smaller cash buffers to tide them over a period of high inflation. The recent Household Pulse Survey data confirm these tendencies. Households with incomes ranging from $25,000 to $35,000 in 2021 were about 19.3 percentage points more likely to be very stressed by inflation than households with incomes in the $75,000 to $100,000 range (Chart 3). By contrast, households earning $250,000 or more last year were over 25 percentage points less likely to find recent inflation very stressful. The large effects of income on the incidence of high inflation stress in Chart 3 could be overstated if income is correlated with other factors that also generate high inflation stress. However, the estimated marginal effects of income on the incidence of high inflation stress are only a little smaller, holding constant other factors such as household size and composition, marital status and housing tenure (Chart 4). This finding that high inflation is disproportionately hurting low-income households may surprise some commentators since tight labor markets have compressed wages. Although lower-wage earners are currently experiencing higher wage growth than middle- and higher-wage and salary earners, the Household Pulse Survey results clearly indicate this has not been sufficient to offset the impact of high inflation. The incidence of high inflation stress is a good deal greater for Black and Hispanic individuals than for others; 57.2 percent of Hispanics reported inflation stress, 53.7 percent of Blacks, 43.6 percent of whites and 38.6 percent of Asians. However, differences between the groups mainly reflect income differences. Relative to a white respondent in the survey, the marginal effect of being Hispanic is only 3.8 percentage points, while the marginal effects of being Black or Asian are not significantly different from zero from a statistical standpoint. Because rents have been one of the largest drivers of inflation, renters are more vulnerable to shelter inflation than owner occupants with a mortgage since most have low fixed-rate mortgages and are not affected by rising mortgage rates. By contrast, the majority of renters face annual or more frequent rent reviews and have experienced quite large cost increases over the past year. We find that 56.5 percent of those paying rent were very stressed by high inflation as opposed to 43.4 percent of homeowners with a mortgage and 39.3 percent of owners without a mortgage. Renters generally have lower incomes than homeowners, so we looked at the marginal effects of renting versus owning. They suggest that, holding other factors constant, renters are on average 3.1 percentage points more likely to feel very stressed by inflation than owner occupants with a mortgage; homeowners without a mortgage were 3.3 percentage points less likely than renters to be very stressed by inflation. Although couples can live more cheaply than single people, high inflation is more stressful for couples, especially ones with children. At the margin, an extra adult increases the chances of high inflation stress by 2 percentage points, and an extra child raises that stress by 4.2 percentage points. Age plays a role as well—other things being equal—as younger (under age 25) and older individuals (age 65-plus) are not as stressed by high inflation. Inflation is far too high and is particularly stressful for lower-income households—including many Black and Hispanic families, families with children and renters. As Fed Chair Powell noted: “Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all.” This is why it is important to tackle high inflation by raising interest rates, tightening financial conditions and curbing excess demand.