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Getting inside the Fed's head

The task currently facing the Federal Reserve is daunting: Getting inflation back to target without causing the economy to stall.

Whether it succeeds will likely hinge on the evolution of three key policy drivers and the Fed’s response to them: inflation expectations, energy prices, and spare capacity in the economy.

Our proprietary model, described in detail in a forthcoming publication, helps us understand how the Fed might respond to the evolution of those three key drivers and what that might mean for the economy and policy rates.

Using the Fed’s June 2022 economic projections as a starting point, the model focuses on three scenarios the Fed could face in the coming months—a hard landing, stagflation, and a softish landing.

Scenario 1: A hard landing

We believe that the Fed plans to reach a terminal rate (the level at which the Fed’s benchmark interest rate peaks during a tightening cycle) of at least 4% by next year. That relatively hawkish stance stems from fears that high inflation could become entrenched into the economy through a wage-price spiral driven largely by uncertainty around energy supply and related price shocks in this tightening cycle.

But what if these concerns about the policy drivers turn out to be misplaced? Inflation expectations might turn out to be more stable or “anchored” than expected. This would put a brake on the wage-price spiral, and inflation could end up falling faster than expected.

In that case, according to our model, the Fed’s June stance would risk provoking a hard landing. As shown by the dotted line in Figure 1c, the output gap (the gap between the actual output of an economy and its maximum potential) would widen to roughly –1.5% of GDP in both 2023 and 2024.

Faced with a hard landing later this year, the Fed would eventually adjust its policy path lower and, in doing so, would deliver a milder U.S. recession (the solid line in Figure 1c) than if it held to its June projections. This is shown by a smaller widening of the output gap to roughly –1% of GDP in both 2023 and 2024 as the Fed recalibrates its effort.

 Figure 1: The Fed could steer clear of a hard landing by pausing planned rate hikes

a.  Policy turns out to be too restrictive, forcing the Fed to pause


b.   Inflation falls faster than expected


c.   The Fed avoids a deep recession; it’s a moderate one instead

Notes: The projections in this article are based on our New Keynesian model, which relies on three fundamental economic relationships: aggregate demand, aggregate supply, and the formation of inflation expectations. Beginning with the June 2022 dot plot federal funds rate estimate (dotted line in Figure 1a), the model projects an accelerated decline in inflation (dotted line in Figure 1b) that leads to output contraction (dotted line in Figure 1c). If the Fed recalibrates policy (solid line in Figure 1a), affecting our inflation and output gap projections (solid lines in Figures 1b and 1c), the economy would undergo a mild recession. Headline PCE refers to the all-items Personal Consumption Expenditures Price Index.

Sources: Vanguard and “Is the Fed New-Keynesian?” in The Grumpy Economist blog by John Cochrane, as of August 5, 2022.

Scenario 2: Stagflation

Under the stagflation scenario, oil prices are assumed to push higher to settle above $130 per barrel. Moreover, the ongoing war in Ukraine would adversely affect food prices in 2023. These factors could lead to inflation rising more than anticipated and peaking later, thus kindling inflation expectations.

Inflation would therefore fall back at a slower pace than the Fed’s June projections—staying above 4% well into 2023, and staying at around 3.5% thereafter, as the dotted line in Figure 2b shows.

In such a scenario, the Fed would have to play catch-up by raising rates even more aggressively to combat high inflation and rising inflation expectations. Our model suggests that rates could rise above 5% under this scenario, with a high likelihood that the amount or pace of these hikes would surprise financial markets.

Such an extreme move in policy rates would certainly dampen inflation but also provoke a severe recession, with the output gap widening to –1.5% of GDP in 2023, as shown by the solid line in Figure 2c. This is a much wider gap than the –1% in the hard-landing scenario where the Fed eventually backs off from intended rate hikes.

Figure 2: Persistently high inflation could lead to more aggressive rate hikes and a severe recession

a.   The Fed has to tighten more aggressively as it finds itself behind the curve


b.   Inflation remains above target for longer


c.   This drives the economy into a severe recession

Notes: Beginning with the June 2022 dot plot federal funds rate estimate (dotted line in Figure 2a) and more adaptive inflation expectations (meaning expectations give more weight to past readings of inflation and hence are more backward looking), the model projects persistently higher inflation (dotted line in Figure 2b). If the Fed has to play catch-up with inflation and recalibrates the policy path higher (solid line in Figure 2a), affecting our inflation and output gap projections (solid lines in Figures 2b and 2c), the economy would undergo a severe recession.

Sources: Vanguard and “Is the Fed New-Keynesian?” in The Grumpy Economist blog, as of August 5, 2022.

Scenario 3: A softish landing

This third scenario, a “softish” landing in which inflation subsides but with little to no impact on economic growth, is not impossible, but in our view it would require good luck along with good policy. To get here, we would need to see all three policy drivers moving in the right direction: falling oil prices, a re-anchoring of inflation expectations, and more spare capacity in the economy than expected.

If this set of conditions played out, it would show up as some months of deflation (falling prices) and year-on-year disinflation (a decrease in the inflation rate).

That might give the Fed cover to reverse some of the planned rate hikes, allowing the economy to narrowly avoid recession, as shown by the solid line in Figure 3c. The terminal rate of interest would be a little above 3%, with rate cuts possible starting early in 2023. Inflation would converge back to the Fed’s 2% target. Annual GDP growth would rebound in 2023 and settle back on trend much sooner than it would under either a hard landing or a stagflation scenario.

Figure 3: Favorable inflation and output data could allow the Fed to raise rates less than planned

a.   The Fed can reverse some of the planned rate hikes


 b. Inflation will converge toward target


c.   A recession can be avoided

Notes: Beginning with the June 2022 dot plot federal funds rate estimate (dotted line in Figure 3a) and factoring in good luck in terms of the three policy drivers, our model projects a path of gradually falling inflation (dotted line in Figure 3b). If the Fed is able to recalibrate the policy path lower (solid line in Figure 3a), affecting our inflation and output gap projections (solid lines in Figures 3b and 3c), the economy would narrowly avoid a recession.

Sources: Vanguard and “Is the Fed New-Keynesian?” in The Grumpy Economist blog, as of August 5, 2022.

The path forward

The future path of the economy, while always uncertain, seems especially opaque today given the current pace of consumer price increases. The situation raises new and important questions about the central bank inflation-targeting framework, which has been taken for granted for decades.

Our forthcoming paper provides further detail of how the Fed might recalibrate policy in response to incoming data and trends. It lets us build scenarios such as those outlined above that anticipate how high interest rates might go under different scenarios for inflation, energy prices, and economic growth. Getting inside the Fed’s head is not easy, but it is worth a try.

Contributors: Vanguard European Chief Economist Jumana Saleheen, Vanguard senior economist Asawari Sathe, and Vanguard economist Roxane Spitznagel.


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