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The Fed: The Fed could get lucky or things might go wrong. A guide to where the economy might go from here

Is a recession inevitable? Will the Federal Reserve cause it?

Although superlatives about the U.S. economy have been overused in the wake of the pandemic, it is fair to say that the economy is at a remarkable crossroads with outcomes ranging from soft to hard landings and to stagflation all possible.

“I think there are several different possible futures ahead of us,” said Wendy Edelberg, the director of the Hamilton Project and senior fellow in economic studies at the Brookings Institution, during a recent Brooking Institute discussion on inflation.

Here is a handy guide for investors interested in how the economy could evolve over the next 17 months.

Often the Federal Reserve can remain a bit aloof from the economic data, looking for trends to develop over six months or longer before reacting.

Now however, with inflation already at 40-year highs, the Fed doesn’t have the luxury to sit back and observe. It is going to be reacting to every scrap of data. Even food and energy inflation can’t be overlooked in this environment.

It’s like a card game. The Fed is going to look at the cards dealt by the economy and decide how to play its hand. How Fed Chairman Jerome Powell and his colleagues react will be key to the outlook.

“The Fed could make a mistake and create a massive recession or the Fed could make a mistake and actually do an incredibly great job,” said Justin Wolfers, a professor of public policy and economics at the University of Michigan, during the Brookings event.

The Fed gets lucky – even a mild recession

If the economy slows in coming months and inflation also softens, “that is basically a success,” said Edelberg of the Hamilton Project, in a follow-up interview with MarketWatch.

That’s a soft landing. It could even be a mild recession, one that doesn’t feel much different than ‘slow’ growth, she said. In essence, a shallow recession would be the economy taking a breath after the craziness of the past year and a half, she said. “This will all be a grand success if we have a soft landing, Edelberg said.

The Fed overdoes it – a bad recession

Under this scenario, the Fed is spooked by high inflation and slams on the brakes with higher interest rates even as the economy is slowing on its own. While the result of the Fed action will be slower economic growth and lower inflation, the amount of damage to the labor market would be unnecessary.

Economists at BlackRock Investment Institute think there is going to be a new regime of volatility in both growth and inflation. The Fed is going to choke off the recovery and only change course when the damage is done.

“They are not acknowledging the stark trade-off: crush economic activity or live with inflation,” they wrote in a note to clients.

The nightmare scenario – stagflation

This is several scenarios under the same umbrella.

Essentially some economists think inflation will stubborn and not melt during any downturn.

“Inflation is a problem. It is going to stay a problem, It isn’t going to come down fast anytime soon,” said Jim Bianco, president of Bianco Research, in an interview with Bloomberg.

That means the Fed has to stay aggressive – and “a recession isn’t going to stop them,” Bianco added

One reason inflation may be stubborn would be if the American public has come to anticipate higher inflation ahead, Edelberg said. There is a close link between expected and actual inflation.

This may result in the worse-case scenario for the Fed, where the economy and the labor market weaken significantly but inflation remains stubbornly high. This is stagflation.

In this environment, the Fed has tough choices. The central bank will likely be under political pressure to ease up tightening because of the slowdown. If the central bank gives in, that could create a stop-and-start economy and inflation will remain elevated.

The yield on the 10-year Treasury note

has moved up above 3%. It is still below the yield on the 2-year Treasury note
an inverted yield curve that is often the harbinger of a recession.

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