Jerome Powell and the Federal Reserve are still struggling to understand the crazy economy that has been hit by the pandemic and war

In terms of news related to the economy and inflation, this is an important week. On Tuesday and Wednesday, Jerome Powell and his Fed colleagues will hold a two-day meeting, in which they are expected to raise the federal funds rate by another three-quarters of a percentage point. On Thursday, the Commerce Department will release its preliminary estimates of GDP growth for the three months from April to June. Many economists expect a barely positive reading of inflation-adjusted growth – in the range of zero to one percent year on year. The GDP estimate now released by the Federal Reserve Bank of Atlanta, which includes a batch of economic data, expects growth of negative 1.6 percent – a decline.

If the GDP growth rate comes below zero, it will be the second negative quarter in a row, and it will lead to more headlines around the recession. Although the commonly used general rule is that two quarters of negative growth are indicative of a recession, such headlines would be misleading. Still, Powell and his colleagues, like us, struggle to make sense of the pandemic-hit insane economy and war that shows conflicting signs of strength and weakness. According to the Department of Labor, employers created three hundred seventy-two thousand jobs in June, more than economists had expected. Retail spending also came in stronger than expected. Moreover, second-quarter GDP is likely to be negatively affected by the unusual pandemic-related changes in corporate inventories – things that companies made but not yet sold – which could be reversed in subsequent quarters. But, even taking into account all these factors, the economy has certainly slowed significantly this year, and looking ahead, a recession is a distinct possibility. So why is the Fed still expected to raise interest rates, a policy designed to have a disheartening effect on the economy?

Of course, the answer is inflation, which rose to 9.1 percent in June, the highest rate in more than forty years. Having failed to anticipate the global rise in rates that began last year, central bankers around the world are prodding each other to sharply raise interest rates. Last month, the Federal Reserve raised the federal funds rate by three-quarters of a percentage point. Earlier this month, the Bank of Canada increased its fellow Americans by raising the benchmark interest rate by a full point. Last week, the European Central Bank (ECB) offered a half-point increase.

These interest rate hikes came despite some signs that inflation may have peaked. In the past month, the price of crude oil has fallen to about the same level it was before Russia’s invasion of Ukraine. The price of gasoline has also fallen significantly. In June, the average price of a regular gallon nationwide rose above five dollars for the first time, according to AAA. The national average is currently $4.35.

Powell may welcome those developments this week, but he’s also likely to say it’s too early to change course. Despite the recent slowdown in oil prices, the Fed chief and his foreign counterparts fear inflation could get out of control — the very thing that independent central banks, such as the Federal Reserve and the European Central Bank, have been set up to avoid. “We may have reached a tipping point, after which inflationary psychology is spreading and taking hold,” the Basel-based Bank for International Settlements, a kind of central banker, warned last month. Powell got the message and appears determined to raise interest rates so that inflation drops significantly over an extended period. “The danger is that… he warned a few weeks ago at the European Central Bank forum in Portugal. “We will not allow the transition from a low inflation environment to a high inflation environment.”

Even when the Fed chair made hawkish statements like these, he also insisted that a recession is not inevitable. In his press conference after last month’s Federal Reserve meeting, he said the US economy is “very strong and well-positioned to handle tighter monetary policy”. But, if the Fed and other central banks did such a bad job of predicting higher inflation last year, what reason should they expect that they would get things just right from here? The honest answer is not much.

To his credit, Powell has publicly acknowledged the scale of the challenge he and his colleagues face. At the forum in Portugal, he noted that the economic models they have long relied on to analyze inflation — primarily the Phillips curve, which links high inflation to low unemployment — have collapsed since Corona virus pandemic seem. “I think we now understand better how little we understand inflation,” Powell admitted.

It’s not just inflation that proves the puzzle. The minutes of the Federal Reserve’s June meeting indicate that its officials are struggling to know how seriously to take all the talk of a recession. “Participants saw that uncertainty about economic growth over the next two years had risen,” the meeting minutes said. “Two of them noted that GDP and GDP have been giving mixed signals lately on the pace of economic growth, making it difficult to determine the underlying momentum of the economy.” This is Fedspeak for “Right now, we’re at a loss.”

Faced with all this confusion and uncertainty, Powell and his colleagues will probably be relieved not to have another meeting until the second half of September. At this point, what happens to inflation and growth should be more clear — or, at least, that’s what Fed officials are hoping for as they face a decision on whether to moderate, or even halt, interest rate hikes. Given the experience of the past two and a half years, they should expect the unexpected. ♦