A Recession Is Not Inevitable

For the past few months, one phrase has been on the mind of investors and policy makers alike: soft landing. With the Federal Reserve raising interest rates at a rapid pace since last spring in an attempt to bring down inflation, the fundamental question has been whether those hikes (and any future ones) will tip the economy into recession or instead slow it enough to cool inflation without sending the economy into reverse.

Objectively, things look pretty good. Inflation seems to be coming under control—the month-on-month inflation rate actually fell a bit in December, while prices for wholesale goods and services tumbled sharply. At the same time, unemployment is at historic lows, and the U.S. economy is still creating a respectable number of jobs. (For all the talk of layoffs, unemployment claims in mid-January were below 200,000.) Wage growth has slowed, and the supply-chain disruptions that helped fuel inflation last year seem mostly to be fixed. The landing strip, in other words, is in sight.

There is, however, an obvious problem with this prospect: the Federal Reserve itself. The Fed’s governors, a number of whom made hawkish comments last week, are still committed to bringing inflation (currently running at 5.7 percent) all the way down to their 2 percent target. And if they follow through on that plan, it’ll be very hard for the American economy to avoid a recession.

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What’s odd about this is that there’s nothing special about 2 percent as a target. It’s an arbitrary number whose origins date back to an offhand remark made by a New Zealand central banker named Don Brash in the late 1980s. But over the years, the 2 percent mark has been generally accepted as the definition of price stability. So it has become the inflation target that central bankers in the U.S., Canada, the U.K., Europe, and Japan all shoot for.

To be fair, 2 percent has certain virtues. Central bankers don’t aim for zero inflation, because undershooting can lead to a deflationary spiral and act as a drag on economic growth. In that context, 2 percent has a practical air: not too low and not too high. At an annual 2 percent, prices double every 35 years, which is a long-enough time horizon that no one stresses too much about it. And for most of the past three decades, the Fed was able to keep inflation at or below 2 percent without much trouble.

Now, though, that target, and the Fed’s dedication to it, could have serious consequences both for American workers and for American companies. Although getting inflation down to the 3 percent range doesn’t seem too hard—we may already be on our way—getting it down quickly by an additional percentage point will be challenging. That will likely require the Fed to keep pushing up interest rates, which will in turn squash economic growth, put more people out of work, and increase the odds of a hard landing.

That’s why a surprising number of high-profile figures on Wall Street have started to question the value of the 2 percent target. In December, the influential hedge-fund manager Bill Ackman tweeted that reaching the 2 percent target could not be done without a “deep, job-destroying recession.” Wilmington Trust’s chief investment officer, Tony Roth, argued recently that “3% is the new 2%.” And last week, Morgan Stanley CEO Jim Gorman questioned whether 2 percent was still a realistic goal for the Fed.

That is a good question. The global economy has changed a lot over the past 15 years, since the Great Recession, and even over the past three years of the pandemic. Millions of workers have left the workforce and don’t appear to be coming back. The supply-chain problems of recent years, as well as the rise in tariffs and other trade barriers, have led to more onshoring of jobs and domestic production, which will reduce the deflationary benefits that outsourcing to cheap-labor countries such as China and Vietnam once produced. And the transition to alternative energy may also raise energy costs in the short term.

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What all of this means is that driving inflation down to 2 percent may be unrealistic without inflicting a lot of unnecessary pain. And if you’re looking for an inflation rate compatible with strong economic growth, 3 percent may be a more realistic target than 2 percent. There is nothing sacred about 2 percent—the Bank of England, in fact, started its response to the current bout of rising prices with a wide range of acceptable inflation, from 1 to 4 percent, before adjusting its target to 2.5 percent, and then at last falling in line with everyone else on 2 percent. In addition, raising the target to 3 percent would obviously make the Fed’s job easier.

Unfortunately, this is not going to happen. The Fed feels that its credibility is on the line: If it changed its policy now, people might assume that next time around, it would ratchet up its target again. (Former Treasury Secretary Larry Summers made this exact argument last week, saying that abandoning the 2 percent target “would do very substantial damage to credibility,” and could lead to a 1970s-style crisis.) And the Fed is already leery because of criticism that it let inflation get out of control in the first place. When Fed Chair Jerome Powell was asked last month about adjusting the target, he shot down the idea immediately. “Changing our inflation goal is not something we’re thinking about,” he said. “We’re not going to consider that under any circumstances.”

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That sounds about as definitive as you can get, and it does mean that the odds against a soft landing are higher than they otherwise would be. But there is a little wiggle room here. Although 2 percent is the target, inflation was well below that for plenty of periods in the past. So a period of inflation above it should not be inherently intolerable. More important, even if 2 percent is the target, the Fed faces no absolute requirement on how quickly we get there. So the Fed could raise interest rates a bit more, and then pause to see how that affects the economy, without abandoning the 2 percent goal.

Getting inflation under control is part of the Fed’s job, and it’s an important one. But so, too, is maintaining “maximum employment.” As it navigates the year ahead, the Fed should be balancing those two tasks, rather than obsessively pursuing that 2 percent target at the expense of jobs. Right now you can see a path to a classic soft landing. Let’s hope the Fed doesn’t turn it into a crash instead.