Raghuram Rajan considers the US Fed's limited options as it navigates an increasingly perilous economic environment

The US Federal Reserve is clearly determined to bring down inflation. But no one really knows how high it will have to raise its policy interest rate – and how long it will have to keep it there – to achieve its objective. Many are thus wondering whether the Fed will bring on a recession.

Inflation is coming down, partly because snags in supply chains have been sorted out, but also because demand is weakening. Higher interest rates have slowed home purchases, and hence housing construction. Higher-priced goods and services have eaten into household budgets and impeded consumer spending. And China’s anemic growth has dampened commodity prices globally.

The Fed, however, is not satisfied with the current situation. It fears that until some slack emerges in America’s red-hot labour market, wages could still catch up with inflation and then push it higher. The last thing the Fed wants is to hit pause and then see inflation ramp up again as financial markets celebrate and financial asset prices rise, reigniting demand. That would force policymakers to raise rates higher, and for longer. “One and done” would be far better than “rinse and repeat,” both for the economy and the Fed’s reputation.

Moreover, the Fed does not necessarily believe that more slack in the labour market means much more unemployment. Ideally, the ratio of job openings to unemployed workers would come down, with job openings falling significantly. But even if unemployment rises modestly, the Fed will not be deterred. It has concluded that if the economy slows too much, it can always be stimulated back to growth through rate cuts. Hence, the consensus is that the Fed will err on the side of doing too much, as that would still allow it to keep any downturn mild by cutting rates. Indeed, market prices suggest the Fed will be back to cutting rates later this year.

What could go wrong in this consensus view? Consider two alternative scenarios. First, the Fed might push the economy into a recession, but inflation could still settle stubbornly above its 2% target. Such stagflation – resembling the 1970s, when inflationary expectations became entrenched at higher levels – would impel the Fed to raise rates even further at the same time that the economy is shrinking. It is here that the Fed’s inflation-fighting zeal, and its ability to withstand political pressure, would be truly tested.

A second possibility is that inflation will come down, but with a sharp (rather than a gentle) fall in growth. Consider the current labour market. Not only have small and medium-size firms struggled to find workers, but, thus far, they have been holding on to employees even as large firms announce layoffs, precisely because they know how hard hiring has become. In fact, some are still hiring, encouraged by the prospect of recruiting more high-quality workers now that the big firms have shut their doors.

But as slack builds up in the labour market, these smaller firms may become more confident that high-quality workers will remain available into the future. In that case, they, too, might pause hiring, or even shed some of the workers they hired when labour markets were tight. Put differently, the stream of layoffs that we are already seeing may become a flood.

That would affect other markets. For example, US home sales have slowed considerably, but house prices have generally held up, probably because there is not much supply entering the market. With mortgage rates having risen by so much over the past year, a homeowner with a 30-year mortgage at 4% will have to shell out much more in monthly payments if she upgrades to a slightly better house with a new mortgage at 7%. Because she cannot afford to buy, she does not sell. And because this dynamic is limiting the supply of homes on the market, there is little downward pressure on prices.

If layoffs increase, however, more homeowners will not be able to make even their 4% mortgage payments, and they will be forced into distressed sales. Supply will suddenly increase, home prices will fall sharply, and the combination of greater employment uncertainty and lower housing wealth could shatter consumer confidence, further reducing growth.

Now consider another potential domino. We have just gone through a three-year period in which corporate bankruptcies fell, owing not least to pandemic-related fiscal support. Yet notwithstanding some recent signs of corporate distress, it would seem that many more “walking wounded” firms ought to be folding. Why aren’t they?

One reason is that many firms refinanced in the early months of the pandemic, taking advantage of easy credit conditions to extend the maturity of their debt. But the most vulnerable firms could do only so much at the time, and soon the volume of maturing corporate debt will increase. If that debt has to be rolled over in an environment of increasing economic gloom, it is a fair bet that many will not be able to refinance, and corporate bankruptcies will increase significantly. The mainstream financial sector may have been smart enough to steer clear of crypto, but it is not immune to household and corporate distress. And as we know from history, financial-sector losses can quickly lead to catastrophic scenarios.

In these two scenarios, the Fed at least knows what it will have to do in the first one: raise rates to fight stubbornly high inflation. But if developments are downwardly non-linear, it is hard to see what signposts the Fed can use to navigate between the Scylla of doing too little and having to “rinse and repeat,” and the Charybdis of doing too much and watching the economy fall off a cliff. Perhaps the best thing it can do is guard against complacency about the economy’s ability to bend without breaking, and remain acutely sensitive to incoming data as we enter a period of maximum danger.

Raghuram G. Rajan, former governor of the Reserve Bank of India, is Professor of Finance at the University of Chicago Booth School of Business and the author, most recently, of The Third Pillar: How Markets and the State Leave the Community Behind (Penguin, 2020). Copyright: Project Syndicate, 2023, and published here with permission.