Fed Set to Lift Rates as ‘Soft-ish Landing’ Becomes a Harder Sell

Federal Reserve officials are meeting this week with one major goal in mind: Cooling the economy enough to slow rapid inflation.

The odds of pulling that off without plunging the nation into a recession are growing slimmer.

As the Fed prepares to take an aggressive stance to tamp down persistent inflation — likely discussing raising interest rates by three quarters of a point this week — investors, consumers and economists increasingly expect that the economy could tip into a downturn next year. Even researchers who think the central bank can still pull off a “soft landing,” in which policymakers guide the economy onto a more sustainable path without causing a spike in unemployment and an outright contraction, acknowledge that the path toward that optimistic outcome has become narrower.

“It was not obvious that a soft landing was feasible,” said Michael Feroli, chief U.S. economist at J.P. Morgan, who still thinks it could happen. “The degree of difficulty has probably increased.”

The trouble stems from America’s inflation data, which have been growing more worrying. Consumer prices accelerated in May to an 8.6 percent pace, the fastest since 1981. Even after stripping out volatile food and fuel costs, which the central bank cannot do much to control, inflation was firmer than expected last month as rents, airfares and hotel room rates surged. Compounding the problem, two recent reports showed that inflation expectations are headed higher.

The data suggest the Fed may need to act more decisively, slowing consumer and business spending and the job market even more, to bring prices under control.

Before last week’s inflation report, central bankers had been expected to raise interest rates by half a percentage point at their meeting this week and then again in July. But now the Fed will likely discuss moving more rapidly to try to stamp out inflation pressures before they become a permanent feature of the economic backdrop. They could also continue to raise rates by more than their usual quarter-point increments into September or even beyond, many economists predict.

The Fed has already raised rates twice this year, by a quarter point in March and half a point in May. If it takes more drastic action — making mortgages and business loans even more expensive, choking off corporate expansion plans and crimping the labor market — it would make higher unemployment and a shrinking economy more likely.

For months, the Fed has acknowledged that the path toward slower inflation was likely to be an unpleasant one. When the central bank raises the federal funds rate, it filters out through the economy to slow consumer and business demand, eventually weighing on wages and prices. The way to bring inflation under control is, essentially, to cause a little economic pain.

Still, top policymakers have voiced consistent optimism that because America’s labor market was starting from a solid position, it might be possible to cool down inflation without actually erasing recent job market progress. With so many job openings per unemployed worker, the logic went, it might be possible to restrain conditions just enough to bring the supply of workers into better balance with employer demands.

“I think we have a good chance to have a soft or soft-ish landing,” Jerome H. Powell, the Fed chair, said at his news conference after the central bank’s May meeting, adding that “the economy is strong and is well positioned to handle tighter monetary policy.”

But somebody has to feel the pressure and stop spending for the Fed’s policy to work — and with inflation higher and more stubborn, it will take a bigger squeeze on demand to bring it in line.

In fact, Mr. Feroli at J.P. Morgan said, the Fed’s economic projections — which will be released for the first time since March after this meeting — could show a marked slowdown in growth and an increase in the jobless rate to illustrate that policymakers are serious about reining in the economy and controlling prices. Joblessness is now at 3.6 percent, which is below the 4 percent level that Fed officials believe a healthy economy can sustain over the longer run.

If the Fed has to slow the economy dramatically, it will be a challenge to do that without causing a recession. For one thing, when unemployment spikes, recession tends to follow. Downturns have happened when the unemployment rate rose by 0.5 percentage points over its recent low on average over a three-month period — a relationship called the Sahm Rule, after economist Claudia Sahm.

For another, interest rates are a blunt tool and they work with a lag, and the Fed may simply overdo it.

Investors fear a bad outcome. Stocks sank into a bear market on Monday — meaning they have quickly dropped in value by 20 percent — as investors become nervous that the central bank is about to spur a recession in its quest to tame inflation.

“People think that the soft-ish landing is a dream,” said Priya Misra, head of global rates strategy at T.D. Securities. “That’s the big picture.”

It’s not just Wall Street that is increasingly glum. Consumer confidence fell to its lowest level on record in preliminary data from the University of Michigan survey, and expectations of higher unemployment in a New York Fed survey have been picking up.

Even if the Fed is also becoming more uncertain about its chances of setting the economy down gently, Mr. Powell may not say that. Coming from a top central bank official, a prediction that the economy is headed for tough times might become a self-fulfilling prophesy, shattering already fragile confidence.

“They went from soft to soft-ish — I don’t think there’s another term they can use to say ‘not a complete disaster,’” Ms. Misra said. “I think the markets are calling their bluff, that they won’t be able to achieve it.”

A recession would spell trouble for the White House. President Biden has been sure to emphasize that the Fed is independent and that he will respect its ability to do what it deems necessary to bring inflation under control, even as his approval ratings crack and as the economy heads toward a potentially tough transition period.

“The Federal Reserve has a primary responsibility to control inflation,” Mr. Biden wrote in a recent opinion column. He added that “past presidents have sought to influence its decisions inappropriately during periods of elevated inflation. I won’t do this.”

Even so, some have argued that the central bank should not be the only game in town when it comes to controlling inflation, given the pain its policies inflict. Skanda Amarnath, executive director of the employment advocacy group Employ America, argued that the White House should be taking more aggressive actions to improve gas supply, for instance, to try to offset inflationary pressures.

Trying to choke those off by tamping down demand — what the Fed can do — comes at too high a cost, he argued.

“If you are going to rely on the Fed exclusively to solve this problem, the outlook is not good,” he said.

But most mainstream economists see the Fed as the key solution to inflation, much as it was when Paul Volcker led it during the 1980s. He raised interest rates to punishing, recession-inducing levels to bring down prices that had taken off during the 1970s. That’s why many expect a big move on Wednesday.

A three-quarter point move “would underscore their commitment to avoid mistakes of the 1970s,” said Diane Swonk, chief economist at Grant Thornton. “They are now trying to bring down inflation and keep it down in a more inflation-prone world.”