WASHINGTON, DC – Optimism is growing that the United States can avoid a recession. A Wall Street Journal survey of economists in July found that only 54% expect a recession in the next 12 months, down from 61% in April. Economists at Goldman Sachs have lowered their estimate of the probability of a recession to 20%. Following the release of encouraging consumer price index (CPI) data on July 12, investors have grown more confident that inflation can be tamed without sacrificing economic growth.

This emerging consensus may end up being correct. We are all rooting for a “soft landing” in which inflation continues to glide down toward the US Federal Reserve’s 2% target without the economy shrinking. But I worry that a recession in the next year is much more likely than not.

After all, underlying inflation is still double the Fed’s target, and its downward trend has not made meaningful progress in 2023. Given this reality, it was quite confusing to see so many commentators unfurl a “Mission Accomplished” banner following the latest data release.

True, it is good news that monthly core CPI inflation (excluding food and energy prices) fell to 0.2% in June, down from 0.4% or higher each previous month in 2023. But the Fed needs to be sure that inflation is trending down toward its target rate, and one month’s data does not make a trend. The core CPI index has experienced big drops in a single month before (including in July 2022), only to rise again. Though core CPI grew in June at half its 2023 trend rate, it still rose 4.8% – more than double the Fed’s target – over the past 12 months.

More to the point, core CPI is not the measure the Fed is most interested in. Rather, it focuses more on the core personal consumption expenditures price index, which has shown no improvement in 2023. And even if it does register an improvement for June, that, too, will be one data point, not a trend.

Though the Fed has hiked its policy interest rate by 500 basis points, much of the effect of those increases may have already hit the economy. Monetary policy slows the economy by tightening overall financial conditions – that is, by reducing stock prices and increasing longer-term interest rates and the value of the dollar. When the Fed started raising rates last year, financial conditions behaved as one would expect. But conditions have not tightened over the course of 2023, which suggests that those previous rate increases may have already been absorbed.

Despite the Fed’s rapid rate hikes from near zero to around 5.1%, monetary policy may still not be all that restrictive. According to my calculations, the real (inflation-adjusted) interest rate is around 1.5%, which is one percentage point higher than the Fed’s estimate of the neutral real policy rate (which neither stimulates nor reduces economic activity). Prior to previous recessions, the real rate has been higher.

While current market pricing suggests that the Fed will increase the federal funds rate once more this cycle, I think that is optimistic. Between stubborn and high underlying inflation, financial conditions that aren’t tightening, and real interest rates that are lower than is typical before a significant economic slowdown, there are ample reasons for the Fed to raise rates more than economists and investors currently seem to expect. If that happens, the risk of recession will increase.

Moreover, the lower the inflation rate falls, the more likely it is that the unemployment rate will climb into recessionary territory. So far, inflation has fallen without the unemployment rate rising. But standard models of the relationship between unemployment and inflation suggest that the costs of disinflation rise as the rate of inflation falls.

From April 2021 until May of this year, consumer prices grew faster than average wages, which meant that businesses could still raise prices faster than their labor costs increased. But that is no longer the case. Now, the businesses most exposed to labor costs will face increasing pressure to resort to layoffs if consumer price inflation continues to fall.

Finally, historical experience advises against predictions of a soft landing. In a soft landing, the unemployment rate would increase as economic growth fell below its potential rate, but it would remain out of recessionary territory. In the past, however, when the unemployment rate has started to rise a little, it then goes up a lot more. Since World War II, a 0.5 percentage point increase in the unemployment rate in a given year has been followed by a two-point increase. This could be because recessions are driven in large part by a loss of confidence among businesses and households about the near-term future. When managers see that other companies are laying off workers, they are more likely to worry about maintaining profits and lay off some of their own.

Yes, the odds of a soft landing have certainly increased in recent months. The outlook for shelter inflation will put downward pressure on core inflation, and demand could fall with the reduction in bank lending and the depletion of excess household savings. The labor market is indeed cooling. All these factors could well put underlying inflation on a downward trend. In addition, to the extent that labor-market tightness was driven more by high levels of job openings than employment, cooling could be achieved through relatively small increases in unemployment.

But the Fed should not stop raising rates until there is clear evidence that core inflation is on a path to its 2% target. That evidence does not exist today, and it probably will not exist by the time the Fed meets in September. The longer it takes for that evidence to materialize, the higher interest rates will go, and the smaller the chance of a soft landing.

BUENOS AIRES – After more than a year of aggressive monetary tightening, inflation in the United States and around the world is finally trending down. Cautious celebration is in order: monetary policy can be effective, and central banks, after abandoning the fiction of “transitory” inflation, have retained enough credibility to respond effectively.

Contrary to the projections of standard macroeconomic models, and despite the US Federal Reserve raising its policy rate to a 22-year high, the ongoing disinflationary process has not triggered significant output losses or massive unemployment. Apart from some self-inflicted policy mistakes that caused several US banks to fail, disinflation has been relatively painless thus far.

Moreover, emerging markets have taken the lead in fighting inflation, initiating monetary-policy tightening almost a year before the Fed and other major central banks did, and they have successfully avoided the financial stresses that have plagued them during the Fed’s previous tightening cycles.

But the world economy is not out of the woods yet. While recent figures have been encouraging, bringing down inflation is just one part of the post-COVID-19 recovery process, and it is still unclear whether these trends will persist.

What is certain is that ignoring the historical context of economic developments is a recipe for policy mistakes. Contrary to popular belief, the roots of today’s inflation crisis run deeper than the COVID-19 crisis. While the spike in inflation and subsequent interest-rate hikes are frequently attributed to excess demand triggered by the fiscal and monetary response to the pandemic, these measures merely exacerbated imbalances created by the policy response to the global financial crisis (GFC) of 2008-10.

Major central banks’ balance sheets have more than tripled since 2008, as a decade of quantitative easing (QE) led to strong monetary growth and spurred an unprecedented bond-buying spree. Even in emerging markets, central banks’ balance sheets expanded significantly during the pandemic.

While these ultra-expansionary monetary policies undoubtedly played a crucial role in mitigating the worst effects of the GFC and the COVID-19 crisis, they also generated enormous macroeconomic imbalances, such as ballooning money supply and excess bank reserves. This, in turn, created massive risk-taking incentives, encouraged higher levels of public and private debt, inflated speculative asset bubbles, and skewed resource allocation toward short-term yields and away from real investments. As we have noted previously, the direct and indirect bailouts that characterized the “whatever it takes” era have led to an enormous build-up of moral hazard.

Moreover, post-GFC financial reforms inadvertently encouraged regulatory arbitrage, paving the way for an exponential increase in the share of financial assets held by lightly regulated nonbank financial institutions such as hedge funds and crypto exchanges. These institutions currently account for roughly half of all financial assets, thereby exacerbating systemic risks.

To be sure, the current bout of inflation was also driven by other factors, such as pandemic-related supply-chain disruptions, Russia’s full-scale attack on Ukraine, the escalating rivalry between the US and China, and the growing economic nationalism reflected in broad-based industrial policies. By rapidly tightening their monetary policies to control inflation, central banks may have aggravated some of these issues, triggering bank distress and potentially even a recession. The fact that they face significant challenges in unwinding their bloated balance sheets and addressing related perverse incentives further complicates matters.

Central banks missed the opportunity to embark on serious quantitative tightening in the post-GFC decade. Then, when Silicon Valley Bank collapsed in March and threatened to trigger a banking crisis, the Fed intervened by implementing a round of QE that effectively reversed two-thirds of the modest balance-sheet reduction it had previously initiated. Moreover, the US government also stepped in and guaranteed all deposits in the affected banks, regardless of their status and size, setting a dangerous precedent for future bailouts. In Europe, despite overall monetary tightening, the European Central Bank has continued to conduct a sub-QE policy with the Transmission Protection Instrument, under which it purchases bonds from riskier eurozone sovereigns such as Italy.

All in all, while inflation’s downward trend and the containment of the incipient banking crisis provide some relief, the world’s major economies are still grappling with distorted incentives and massive inherited imbalances, some of which are still growing.

These factors are further compounded by strong political pressures for increased government involvement in the economy. In several advanced economies, the government’s response to the COVID-19 crisis, which included government transfers, subsidized handouts via the central bank, and many regulatory exemptions, has created a growing demand for broad government intervention and bigger government. While this is necessary in some areas, particularly when it comes to accelerating the green-energy transition through targeted industrial policies, addressing other important problems, such as inequality or outdated infrastructure, should be carried out within existing government processes and budget constraints.

Governments’ growing involvement in the economy has also raised expectations of additional public support and bailouts, fueled by populist politicians from both the right and the left. Regardless of their political leanings, no government appears willing to accept even minor economic distress these days. The GFC and the COVID-19 crisis have institutionalized bailouts that imply far-reaching moral hazard.

Crisis-resolution measures have increased concentration in the financial sector and elsewhere, such as the already concentrated tech industry. Moreover, the rapid proliferation of private currencies has challenged central banks’ monetary sovereignty, prompting them to develop their own digital currencies. As one of us recently wrote, this will further increase central banks’ footprint in the financial sector.

This confluence of populist governments, economic nationalism, interventionist central banks, and oligopolistic markets could undermine the basic tenets of entrepreneurial capitalism and usher in a new era of state capitalism across the developed world.

Given populist governments’ reluctance to raise taxes, deficit financing and related inflationary pressures are also likely to persist. At a time of heightened risk-taking and macroeconomic and geopolitical uncertainty, any celebration of progress in combating inflation must be cautious indeed. There is still a long road ahead.

CAMBRIDGE – A skydiver leaps out of an airplane and discovers that his parachute will not open. On his way down, he encounters a hang glider who asks him how he is doing. The free-falling man shouts back, “Okay, so far!”

For many, the US economy these days bears a striking resemblance to the parachutist. Ever since March 2022, when the Federal Reserve began to hike interest rates and shrink its balance sheet, the consensus among economists has been that the United States is headed toward a hard landing. Many economists have been confidently forecasting a recession for over a year, with some even asserting that the economy has already started to contract.

The inverted yield curve in bond markets suggests that the financial sector has also been bracing for a recession. In fact, the term “recession” has appeared more prominently in news media over the past year than is typically the case during an actual downturn. This view has clearly resonated with the general public, with a May 2022 poll finding that 55% of Americans believed that the US was already in a recession, compared to 21% who disagreed.

But all these predictions have been far off the mark. The US economy did not enter a recession in 2022, nor is it necessarily headed for one in 2023 or 2024. Similarly, the global economy has avoided a contraction.

To be sure, aggressive monetary tightening is often followed by a slump. But that does not mean that a hard landing is inevitable. After all, if the Fed were to pull off a soft landing, would it not resemble our current situation? Perhaps our metaphorical parachute has already deployed, and what we are witnessing is the US economy’s gradual, controlled descent.

What constitutes a “soft landing” remains open. As several critics have argued, the Fed is unlikely to achieve its goal of bringing down inflation to 2% by 2024 without causing a sharp increase in unemployment and drop in GDP.

But a soft landing might best be defined as a gradual slowdown of output growth and employment to levels below their potential and natural rates, accompanied by a decline in inflation. To qualify as soft, this economic slowdown must not develop into anything more severe than a very mild recession. But inflation need not reach 2% immediately. While US employment and output have indeed slowed in 2022, this is relative to 2021, when the economy recovered rapidly from the previous year’s recession. Despite the monetary tightening, GDP growth has averaged 1.8% over the past four quarters.

Surprisingly, recent data indicate that the US labor market has remained exceptionally strong. Over the first half of this year, job growth averaged 278,000 per month. This, too, is often labeled a “slowdown,” and it is – but only when compared to 2022. Given that the average monthly increase in employment since 2001 has been 87,000 and that total monthly population growth is roughly 100,000, the current rate of job growth is rapid by any relevant standard. Moreover, the unemployment rate remained steady at 3.6% in June, nearly matching the low levels of the late 1960s. The current job market is anything but recessionary.

There is also good news on the inflation front. The June Consumer Price Index (CPI), released last week, showed a 12-month inflation rate of 3%. This represents a significant decline from June 2022, when the inflation rate peaked at 9.1%.

Falling rental costs suggest that CPI inflation will likely continue to decline in the coming months. To be sure, some of the decline in headline inflation since 2022 can be attributed to volatile food and energy prices, which were also among the main drivers of the preceding inflationary surge. But even when food and energy are excluded, 12-month core CPI inflation was 4.8% in June, down from 6.3% in October 2022. Personal consumption expenditures inflation – the Fed’s preferred measure – was at 3.8% in May, down from its June 2022 peak of 7%.

A severe recession might have enabled the Fed to achieve its stated goal of bringing down inflation to 2% this year. But if avoiding the social costs of a serious contraction means stabilizing inflation at 3-4%, with 2% as a longer-term goal, that seems like a worthwhile tradeoff. Such an outcome should be considered a soft landing.

Of course, there is a sense in which a recession is inevitable. Every economic expansion must end at some point. But, contrary to popular belief, there was no reason to declare a slump in 2022, nor is there reason to predict one this year or even in 2024. The probability of a recession is roughly 15% in any given year. Even though the chances of a recession are much higher now, owing to the Fed’s rapid interest-rate hikes, I would still put the likelihood of one happening in the next 12 months at less than 50%.

Like the proverbial skydiver, the US economy jumped out of a plane more than a year ago. It is currently being buoyed by an unusually powerful updraft, preventing a rapid descent. Despite the confidence with which many predict a recession, the parachute might still deploy as planned, allowing the economy to achieve a soft landing after all.

AUSTIN – Back in 2021 and early 2022, a posse of prominent economists – including Lawrence H. Summers, Jason Furman, and Kenneth Rogoff, all of Harvard – criticized the Biden administration’s fiscal and investment program, and pressured the US Federal Reserve to raise interest rates. Their argument was that inflation, fueled by federal spending, would prove “persistent,” requiring a sustained shift to austerity. Unemployment, sadly, would have to rise to at least 6.5% for several years, according to one study touted by Furman.

While this trio (and many like-minded commentators) failed to sway the White House or Congress, they were in tune with Fed Chair Jerome Powell and his colleagues, who began hiking interest rates in early 2022 and have kept at it. The Fed’s rapid monetary-policy tightening soon prompted progressives, led by Senator Elizabeth Warren of Massachusetts, to fear that it will trigger a recession, mass unemployment, and (though they didn’t say it) a Republican victory in 2024.

But the macroeconomic situation today has confounded both positions. Contrary to those advocating austerity, inflation peaked on its own in mid-2022 (owing partly to sales from the US Strategic Petroleum Reserve). There was no persistence, no surge from the 2021 fiscal stimulus, and no wage-driven inflation from low unemployment. The models and historical precedents that the Harvard trio had relied on clearly no longer apply (if they ever did).

There also has been no recession, unemployment has not risen, and higher interest rates have not deterred business investment. Residential construction took a hit, but the construction sector overall soon shook that off, and the banking crisis earlier this year has not led to financial contagion. A recession remains possible, of course, but so far there are very few warning signs.

These happy circumstances have led some observers to congratulate Powell and the Fed on achieving a “soft landing.” But crediting the Fed is magical thinking. There is no way, under any theory or precedent, that rate hikes beginning in January 2022 could have knocked back inflation by July of the same year. Whatever its consequences down the road, the Fed’s policy tightening has been irrelevant to the inflation slowdown so far.

But why haven’t 18 months of rising interest rates had any perceptible effect on employment, investment, or growth? That is as much of a puzzle for progressives as the fall of inflation is for austerians – especially considering that the pandemic-driven boost to household savings has ended, and Congress has started cutting back modestly on various spending programs.

Part of the answer surely lies in new tax incentives for investment, notably in semiconductors and renewable energy. But those sectors are fairly small, and their growth will have accounted for perhaps a hundred thousand jobs. Another part of the answer may lie in direct investment by companies fleeing Europe’s industrial decline, itself a byproduct of sanctions against Russia. But, again, these numbers cannot be very large.

What else is going on? One factor, suggested to me by Robert Aliber, an emeritus professor of economics and international finance at the University of Chicago, is that the top quarter of US households became cash-rich during the pandemic. These households represent the largest share of US purchasing power, and their spending is largely immune to high interest rates.

Another suggestion comes from Warren Mosler – the godfather of Modern Monetary Theory – who notes that US national debt has risen to nearly 130% of GDP, up from about 60% in the early 2000s. The net interest paid on that debt increased by 35% from 2021 to 2022 – reaching 2% of GDP – and about 70% of those payments went to the US private sector. If one adds the effect of interest paid (starting in 2008) on $3 trillion in bank reserves, the fiscal support through this channel has been substantial.

History supports Mosler’s conjecture. Back in 1981, US federal debt was only about 30% of GDP, and much of it was in fixed-interest, long-term bonds, with no interest paid on bank reserves. As a result, then Fed Chair Paul Volcker’s shockingly large interest-rate increases mostly hit private debtors and business investment, and the offsetting fiscal boost from interest payments was small.

In contrast, when the federal debt exceeded 100% of GDP in 1946, almost all of it was in war bonds held by US households. Despite yielding only 2% in interest, those bonds provided a boost to private incomes and a base for mortgage borrowing through the 1950s – a time of largely stable middle-class prosperity.

The “fiscal channel” for interest-rate payments is an inconvenient concept for those who wring their hands over the “burden” of public debt. It suggests that Powell’s rate hikes may be powerless to slow GDP. Indeed, additional rate increases could even be expansionary, at least up to a point.

As in other extreme cases – like Argentina, where interest payments amount to a quarter or more of GDP – rate hikes will increase costs for businesses, pushing up prices, and also apply price pressures on fixed assets (land, minerals, oil) that will show up in our inflation measures. That, in turn, will discourage saving, spur borrowing, and impel the Fed to raise rates even more.

Over time, this process will lead toward economic chaos. But, if this narrative has merit and high interest rates don’t bring on the recession that the Fed so clearly desires, it will be difficult to change course. Ideology and habit can nurture the hope that doubling down on an ineffective policy will make it work.

What might stop this dynamic? One answer is severe fiscal austerity, with budget cuts used to provoke the recession that interest rates have failed to bring about. We are already seeing pressure for this option from Wall Street. Last week, Fitch downgraded its credit rating on US sovereign debt, in a move clearly timed to scare Congress as its budget deadlines approach. Such a policy shift, if it is strong enough, would complete the ongoing obliteration of the American middle class.

Obviously, it would be better to do the opposite – to empower the middle class and disempower the bankers. That would means cutting interest rates while regulating new credit flows, controlling strategic prices, and strengthening fiscal support for household incomes and well-paying jobs. People with decent and secure incomes can reduce their reliance on unstable loans.

That is what we ought to do. But don’t hold your breath.