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Inside the Fed's Dilemma: Inflation vs. Recession

United States Federal Reserve building exterior.

Key Takeaways

Investors and policymakers should avoid giving short-term uncertainty too much consideration in their decision making.

Tightening credit conditions have raised the prospect that something in the economy will “break.”

A recession would increase pressure on the Federal Reserve to cut interest rates, complicating its inflation fight.

Navigating the Economic Roller Coaster

Esther George’s rural upbringing and diverse interests have shaped her attitude, perspectives and measured, practical demeanor. These qualities proved invaluable in her role as president of the Federal Reserve Bank of Kansas City.

George retired in January 2023 after working 40 years at the Kansas City Fed, the last 11 leading it. Her tenure as president started and ended on the heels of two crises: the global financial crisis and COVID-19 pandemic.

In a wide-ranging interview with American Century Investments, she said the turbulence and lack of clarity in both events reinforced her view that investors and the Fed should think long term.

“In the short term, as you can see, things can get more uncertain; they can be less clear. So being focused on the long term, I find, is most helpful — particularly in times of this kind of great uncertainty.”

As the Federal Reserve (Fed) tries to rein in the worst U.S. inflation since she began her career in 1982, that message may carry more weight than ever.

Can the Fed Avoid a Recession?

For now, questions center on how the Fed should react moving forward. Its interest rate hikes since March 2022 have brought annual inflation down but far from its 2% long-term target. Meanwhile, recession concerns abound.

It wouldn’t be the first time Fed rate hikes have triggered a recession. But George said that’s certainly not the Fed’s intent.

“That could actually be counter to what the Fed needs to accomplish in terms of bringing inflation down,” she said, noting a recession would pressure the Fed to cut rates before inflation has fallen adequately. “When the economy begins to turn, it becomes all the more challenging for the committee to keep its resolve in the face of a weakening economy.”

Inflation Expectations Guide the Fed

George said inflation expectations — what consumers expect and what household surveys show — will likely guide the Fed’s thinking as it moves forward.

“That’s a very important dynamic for the Federal Reserve,” she said, “because inflation expectations really are the thing that ends up producing future inflation.”

But they’re not the only reason George foresees inflation staying “sticky” for some time. Demographic trends could also play a role since birth rates aren’t keeping up with the number of retirees relying on Social Security and other federal entitlement programs.

In addition, George says immigration remains below pre-pandemic levels. She said such structural changes in the U.S. economy would provide additional challenges in the years ahead.

Banks, Balance Sheets and Breaking Points

In the meantime, the Fed must navigate an economy that has shown recent stress, primarily from the impact of rising interest rates on the banking system. Three U.S. banks have failed since March as unrealized losses have piled up on some banks’ balance sheets.

The Fed, of course, has its own balance sheet, one whose assets and liabilities doubled during the pandemic as it loosened monetary policy. George noted that while the Fed Funds Rate is the central bank’s primary tool, reducing that balance sheet has had a tightening effect in addition to its rate hikes.

She said all the moving parts have raised the prospect that something will “break” the economy and send it into recession. The banks that failed had more exposure to Silicon Valley, more uninsured deposits and more exposure to commercial real estate than most.

However, she said the more fundamental issue that broadly applies to banks is how well they manage their balance sheets in a rapidly rising rate environment. Indeed, asset/liability management is front and center.

Where's the Fed's Stopping Point?

Even though liquidity problems in the banking sector have emerged, credit problems remain benign — so far. Yet, with the Fed’s policy rate rising from near zero to 5% to 5.25% in 14 months, George said it might make sense for the Fed to take a breather.

“I would favor a pause because I think a lot has been done,” she said, citing the balance sheet in motion and fiscal policy in play. “You might want to just see what kind of lags are there. You may have to pick it [rates] up later, or you may find you had done just enough.”

George added that investors can benefit regardless of when the pause occurs. For instance, she said they have higher-yielding options in more viable investment opportunities than they’ve had for a long time. That, and a long-term perspective, are good things in an otherwise uncertain environment.

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American Century prepared this summary based its understanding of George’s presentation. There is no guarantee as to its accuracy or completeness.

The views expressed in this presentation are the speaker’s own and not necessarily those of American Century Investments. This presentation is for general information only and is not intended to provide investment, tax or legal advice or recommendations for any particular situation or type of retirement plan. Please consult with a financial, tax or legal advisor on your own particular circumstances.

Esther George is not affiliated with American Century Investments.

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