The U.S. Federal Reserve may be feeling a little smug this week as its interest rate-setting committee meets for the last time before the summer break. Annual inflation in the United States slowed to just 3 percent in June, the lowest since March 2021. It has fallen even below that of Japan, which traditionally faces inflation challenges, where price growth reached 3, 3 percent. Perhaps most impressive is that unemployment has barely risen and the odds of a recession are declining, despite the Federal Reserve's aggressive 500 basis point rate hikes over the past 18 months. Can President Jay Powell really achieve “immaculate disinflation” of the US economy? If he did, it would make him one of the most successful Fed chiefs. Even the lauded Paul Volcker, who pushed interest rates as high as 19 percent in the early 1980s, ended up pushing American unemployment to its highest level since the Great Depression. Goldman Sachs now sees only a 20 percent chance of a U.S. recession over the next year. Economic activity is resilient. This month, consumer confidence hit a nearly two-year high. The markets are also expectant. A swath of U.S. stocks, not just tech companies, have rallied.
Soft landing,” when inflation falls without triggering a significant recession, is far from guaranteed. For starters, interest rates may still need to rise further. Investors expect a 25 bp increase this week. The Fed's "dot plot" of committee Job Function Email Database members' rate projections also implies one more this year. Last month's drop in inflation to a two-year low was largely attributed to a drop in energy prices, and core inflation remains above double the 2 percent target. Crushing demand further to reduce price pressures would mean more job losses. Vacancies have decreased, but the labor market still looks strong with strong wage growth. The Fed could face a difficult trade-off between its dual mandate of maximum employment and price stability as the goal approaches. In fact, the Bank for International Settlements says the “last mile” of the disinflation process could prove the most difficult. It is also unclear precisely how quickly the Fed's previous rate hikes have passed through to the real economy and will continue to do so.
A recent Kansas City Fed document said the maximum slowdown in inflation could occur a year after tightening, but added that there was significant uncertainty around that estimate. Either way, most economists agree that a significant portion of the rate increases have yet to be felt. That may well drag growth beyond what is currently forecast. Post-pandemic idiosyncrasies also partly help explain the peculiar trifecta of high rates, falling inflation and limited unemployment. Falling savings and fiscal support have underpinned demand, while a shift in spending from durable goods to services has eased some price tensions. An immaculate disinflation scenario will depend on how these factors play out as well. Soft-landing optimism is not just an American phenomenon. Some emerging markets that raised interest rates before advanced economies have already managed to reduce inflation without hurting output too much. European markets are also increasingly hopeful now. Inflation in both the eurozone and the United Kingdom fell noticeably last month and their economies are showing some resilience.