As US inflation reached 7.9% in February 2022, the Federal Reserve decided at its March meeting to raise its rates by 0.25 points. The latest summary of economic projections (2022) from the Federal open market committee (FOMC), published at the same meeting, projects that interest rates will reach 1.9% by the end of 2022. In reaction, the plausibility of a central bank soft landing without dragging the US economy into recession has been the subject of much discussion.
Fed Chairman Jerome Powell told lawmakers in early March that he thought a soft landing was “more likely than not”. The March forecast from the FOMC and the consensus emerging from the Philadelphia Federal Reserve’s survey of professional forecasters confirm this assertion: In both cases, inflation falls back below 3% in 2023 and unemployment remains lower. at 4%.
Lean on history
To examine the plausibility of the Fed’s forecasts, we look here at quarterly data going back to the 1950s and calculate the likelihood of the economy entering a recession within the next twelve to twenty-four months, given alternative measures of inflation. and unemployment.
Our analysis is motivated by the fact that overheating conditions, such as low unemployment and high inflation, are usually followed by short-term recessions. For example, Antonio Fatás showed, in 2021, that the US economy has never experienced significant periods of low and stable unemployment like those predicted by the FOMC.
Our main conclusion is that given the current inflation (close to 8%) and unemployment (which remains below 4%), the historical data suggests a very significant probability of recession over the next twelve to twenty-four months. .
A high probability of recession
Table 1 shows the historical probability of a recession in the year and the following two years, based on contemporary measures of inflation (as measured by the consumer price index, CPI) and the rate of unemployment.
The results indicate that a lower unemployment rate and higher inflation significantly increase the probability of a subsequent recession. Historically, when average quarterly inflation exceeds 5%, the probability of a recession over the next two years is over 60%, and when the unemployment rate falls below 4%, the probability of a recession over of the following two years approaches 70%.
Between 1955 and 2019, there was never a quarter with an average inflation above 4% and an unemployment rate below 5% that was not followed by a recession in the following two years.
The above results do not reflect our choice to use the CPI rather than other measures of inflation or to use the unemployment rate rather than other measures of labor market tightness. On the contrary, the measure of labor market tightness using the job vacancy rate, which we have advocated in our previous work, suggests an even higher probability of recession over the next twelve and twenty-four month. Similarly, using “Core PCE” inflation or wage inflation rather than the CPI leads to the same conclusions.
Some might argue that the historical data presented in these tables overestimates the likelihood of a recession, given that the past two decades have seen a trend towards greater stability in the business cycle. Motivated by this concern, and in order to make maximum use of available information, we use a probit model to predict the likelihood of a future recession given current economic conditions and controlling for a time trend.
A difficult soft landing
Table 2 presents the results of our probit models, showing the probabilities of a recession over the next twelve and twenty-four months for five different specifications of the model. In our basic model, we use a four-quarter average of inflation and a one-quarter lag of unemployment as the main explanatory variables.
To account for the possibility that recession probabilities have declined over time, we also have specifications that include a time trend (column 2) and a dummy variable for years after 1982 (column 3). We find in our regressions that the trend towards greater business cycle stability does not appear significantly once economic conditions are controlled for.
Finally, we include a specification with a dummy indicating whether the economy is more than six quarters away from an economic expansion (column 4), and with the time trend and the expansion dummy (column 5).
These results suggest a very high probability of recession in the coming years, across many specifications of the model. Moreover, they do not reflect our choice to use the CPI as a measure of inflation or the unemployment rate as a measure of sluggishness.
Using wage inflation rather than consumer price inflation yields an even higher probability of recession, and using core consumer price inflation yields similar predictions. Replacing the unemployment rate with the vacancy rate (which we believe is a better indicator of stress) also gives higher predictions of the likelihood of a recession in the next few years.
Taken together, the evidence we present suggests that it is very difficult to engineer a soft landing in a fast-growing inflationary economy.
The Fed is late
Some have argued that there is reason for optimism, as soft landings occurred several times in the post-war period, including 1965, 1984 and 1994. But in each of these periods, inflation and labor market tensions bore little resemblance to the present moment. Table 3 summarizes labor market conditions during these so-called soft landings.
Note: This table uses quarterly averages from the first quarter of the economic contraction cycle.
During all three episodes, the Federal Reserve was operating in an economy where the unemployment rate was significantly higher than today, where the job vacancies to unemployment ratio was significantly lower than today. and where wage inflation was below 4%.
In these examples, the Federal Reserve also raised interest rates well above the rate of inflation—unlike today—and it explicitly acted early to keep inflation from racing, rather than to wait until inflation is already excessive. Nor have these periods been marked by major supply shocks like the ones the United States is currently experiencing.
With inflation close to 8% and an unemployment rate below 4%, the Fed is now way behind the curve and now needs to catch up in an attempt to rein in rising prices. Far from encouraging optimism, the historical experience of the United States shows that the rapid acceleration of inflation always leads to a substantial increase in economic room for manoeuvre.
Our conclusion echoes that of Jongrim Ha, Mr. Ayhan Kose and Franziska Ohnsorge, who argue that returning inflation to target is likely to require a much stronger policy response than currently expected. Furthermore, none of the calculations made in this column take into account the recent supply shocks related to the war in Ukraine, which will only further increase the likelihood of a recession. It is therefore unlikely that the Fed will achieve a soft landing for the economy.