The Fed wants 2% inflation and no recession. History suggests you rarely get both. Here’s why today’s stance looks like burning down the house.
KEY TAKEAWAYS
Prices are painfully high, but recessions inflict far deeper and broader damage through job loss, collapsing confidence, and GDP contraction
Historically, many recessions have followed periods when the Fed held policy rates above a reasonable estimate of r*, keeping monetary conditions too restrictive for too long
The 2018 episode shows how quickly growth and markets buckle once real rates move above neutral; the Fed’s late pivot likely prevented a pre-COVID recession
Today, the real Fed Funds rate is clearly above r*, while labor, credit, and sentiment data all show mounting signs of fatigue and rising vulnerability
The Fed can’t pretend it can crush inflation painlessly; the real risk is overtightening and “burning down the house” with an avoidable, policy-driven recession
MY HOT TAKES
The Fed is overconfident in its ability to fine-tune inflation with deeply restrictive real rates in a structurally weaker, post-GFC economy
Markets and households are far more rate-sensitive than policymakers admit, so the lagged impact of current policy is likely being underestimated
A small overshoot on inflation is far less damaging than a sharp spike in unemployment, yet the current rhetoric still treats inflation as the only villain
The 2018 near-miss should be a cautionary tale, but the Fed appears to be repeating the same mistake with even less room for error
If the Fed refuses to acknowledge asymmetric risks around jobs and growth, the “soft landing” narrative will age about as well as “transitory” did
You can quote me: “History is blunt: the Fed has never killed inflation without breaking something big–and this time the ‘something’ may be the job market.”
Burning down the house. Let’s get something straight. I think prices are too damn high. Too high for cars, houses, haircuts, chicken, crappy takeout food… pretty much everything. You fight tooth and nail to get a mild bump in income only to find it gets eclipsed by the prices of the goods and services you need and want to buy. Let’s call that a given. Can you remember what a recession is like? Do you recall any time in your career where there were simply no good jobs available? Perhaps you weren’t looking for a job during the Great Recession of 2008, but it was pretty rough.
Let me explain in the only way I know how–with a few numbers. DURING the 2008 recession the Conference Board’s Consumer Confidence Index fell from 90.0 to around 25.0. In this case, I am not using consumer confidence as a leading indicator, just a measure of discomfort. Does 25 sound painful? Unsure? It was the lowest level in the indicator’s history which goes back to 1967. And employment? During that recession unemployment rose to as high as 10%. Do you need context? Here is your answer: only once–only one other time in the 1982 recession did unemployment reach that level since 1947. Remember that–for the most part–a recession is a contraction in economic output. So, essentially, a sustained decline in Gross Domestic Product (GDP). The declaration is a bit more complex, but GDP decline is the key factor. The 2008 recession saw GDP decline as much as -4%--the BIGGEST decline since 1948. You may not be aware if you were lucky, but I think it is fair to say that the Great Recession is aptly monikered, based on these numbers alone.
Let’s time machine back to the days just prior to the 2008 recession. There was a housing “bubble” developing and inflation was climbing. CPI went from 1.6% in 2002 to as high as 3.3% in 2004. The Fed, ever vigilant, engaged in an aggressive rate hiking campaign to ease the bubble, bringing Fed Funds from 1% to as high as 5.25% in 2006, but by late 2007 things started looking shaky when a number of subprime lenders began to collapse. The Fed reversed its hiking and began cutting rates later in the year, but it was too late. The global financial system imploded and the Great Recession arrived. The Fed, for its part, added a new chapter to its crusty old playbook. The chapter was ZIRP–zero interest rate policy. It then added another chapter, because Fed Funds effectively near 0% wasn’t enough to stop the bleeding. It had to use Quantitative Easing, or QE, to pry the ship off the shoal.
To be clear, the Fed’s policy did not cause the Great Recession; it was caused by the GFC. Prior to the GFC, however, it can be argued that the Fed was constantly riding the economic brakes, and–for the most part–let up on them for the first time in history. The Fed stayed off those brakes until 2018, when it began to engage them in earnest. The result? Near recession and a stock market drubbing, causing the Fed to pivot once again in 2019 when it let up on the brakes. COVID, which had nothing to do with anything financial or policy caused the next economic contraction and caused the Fed to return to its ZIRP and QE chapters in the playbook. By 2023 the Fed–for the first time in decades depressed the brakes hard in order to fight runaway inflation. Though it has cut rates since, its foot is still firmly on that brake, and it appears, based on comments from Fed officials lately, that it is not planning to let up on those brakes any time soon–at least not in December.
Let’s define brakes, starting with some obscure econometric variable: r-star or r*. r* is the neutral real interest rate–the inflation-adjusted policy rate that keeps the economy in balance, neither stimulating it nor slowing it down. Think of it as the economy’s natural resting heartbeat: when the real Fed Funds rate is below r*, monetary policy is easy and tends to boost growth and inflation, and when it is above r*, policy is tight and tends to cool the economy and raise recession risk. r* isn’t directly observable; it’s an estimate derived from models that look at long-term growth, demographics, productivity, savings behavior, and inflation dynamics. Have a quick look at the following chart and keep reading.
This chart shows the Fed Funds Rate (white line) going back to 1971.The red dashed line is a very rough estimate of r*. Remember, it technically changes over time, but in the post-GFC world most research suggests r* fell sharply. Also, just so my academic friends don’t all collectively yell at me, r* is an inflation-adjusted rate where Fed Funds is nominal. If we agree that–as most researchers do–that r* went from 2 prior to the GFC and closer to 1 after, adding historical inflation expectations of 2% to 3% kind of puts the nominal line around 3%. I know it’s rough, but it works. In any case, please notice how Fed Funds were almost perpetually restrictive prior to the GFC, and during that time the US experienced 5 recessions (red shaded areas). Also please notice how Fed Funds were pretty much on the rise or extremely just prior to all those recessions. My friends, it’s no secret that the Fed and monetary policy was the driver of many recessions prior to the last two. Why do I remove the last two from the equation? Because those were caused by non-natural exogenous factors such as the financial system collapse and COVID.
If you study that chart closely, another point becomes hard to ignore. The moment Fed Funds pushed meaningfully above that rough nominal r* line in the post-GFC era was in 2018. Growth was steady, unemployment was low, and inflation was hardly an emergency, yet the Fed was determined to “normalize” policy after a decade of ZIRP and QE. It kept tightening even as the global economy was rolling over under its feet. Markets cracked, credit spreads widened, PMIs sagged, and yield curves flattened and almost inverted in protest. Powell ultimately delivered his now-famous late-2018 pivot, abandoning the autopilot tightening path and reversing course with three cuts in 2019. It was a narrow escape. And if we’re being honest, the economy didn’t avoid recession because it was fundamentally resilient–it avoided recession because the Fed backed off just in time. Had they stayed on that path another three or six months, we might have experienced a downturn before COVID ever appeared on the radar.
Fast-forward to today, and the setup is far more precarious. We are not brushing against r*--we are clearly above it. The real Fed Funds rate sits north of 2%, the highest in more than twenty years, and you don’t need a doctorate in finance to see the strain. The labor market’s shine is fading around the edges. Job openings have deflated meaningfully. Wage growth is cooling. Continuing claims are drifting up. Small-business sentiment is faltering. Manufacturing remains in contraction. Freight volumes are weakening. Delinquency rates across consumer credit buckets are rising. And don’t forget about the soft data–the confidence surveys, the expectations components, and the diffusion indices–all the little canaries that chirp long before the harder data catches up. Those canaries aren’t chirping anymore–they’re gasping.
None of this automatically guarantees a recession, but it does underscore just how thin the margin for error has become. The modern economy is not built to withstand long periods of deeply restrictive real rates. The post-GFC landscape is one of aging demographics, elevated debt burdens, productivity swings, digital labor markets, and razor-thin household buffers. This is not the 1980s. This isn’t an economy built on manufacturing muscle, high birth rates, and high savings. Consumers today live closer to the edge, and policy takes less time and less force to bite.
I am not ignoring the Fed’s mandate. Inflation remains sticky, prices feel suffocating, and policymakers do not want to repeat the embarrassment of 2021 and 2022 when they misread supply-chain distortions as “transitory.” The instinct to lean hawkish makes sense on some level. No central bank wants to be remembered as the one that blinked too early and allowed inflation to become permanent. But history is pretty blunt on this topic. The Fed has only ever truly defeated inflation by driving demand low enough to push the economy into recession. There it is, I said it. That’s not political spin, that’s empirical fact. Volcker ended inflation by crushing the economy in the early 1980s. Greenspan’s hikes contributed to the 1990 downturn. The early 2000s disinflation cycle required the bursting of a stock bubble and a labor-market shock. The blunt truth: monetary policy kills inflation by slowing the economy until something breaks.
And that’s what makes today’s stance so unsettling. The Fed keeps insisting it can slow inflation the “nice and easy” way, but the playbook doesn’t offer many nice and easy options. Rates this high, held for this long, have historically ended in the same place–a recession. And recessions are not sterile textbook events. They are layoffs and missed paychecks, shuttered small businesses, lost confidence, evaporating savings, and whole industries shrinking for a period of time. They are exactly the scenes I described above, the moments when jobs vanish and household anxiety skyrockets. Anyone who lived through 2008 remembers it viscerally.
The danger now is the Fed’s confidence in its own ability to manage this landing. Policymakers are looking at the backward-looking strength in certain data series and convincing themselves the economy can tolerate higher real rates indefinitely. But slowdowns always look deceptively mild right before they turn. Look back at 2000, 2007, and 2018. In each case, the data still looked “fine” until the moment it didn’t. The Fed has an unfortunate habit of reacting to inflection points only after they have already taken hold.
That is why the setup today feels so much like playing with fire. You have an economy that is showing unmistakable signs of fatigue. You have a real policy rate that is restrictive by any reasonable estimate of r*. You have a Fed that keeps talking tough about pushing inflation back to 2% on schedule. And you have markets and households that are far more sensitive to rate policy than they used to be. It is a script we have read before, and it usually doesn’t end with gentle, painless disinflation. It ends with layoffs, contraction, and unemployment rising until the Fed finally cuts far more aggressively than it currently imagines.
This doesn’t mean the Fed should abandon its mandate or surrender to inflation. It means policymakers must acknowledge the asymmetric risks. Inflation that drifts from 2.5% to 2.7% for a few months is not a crisis; unemployment rising sharply is. Household pain is not an abstraction (though we love abstractions in economic research 📉), it is the thing that defines recessions. And recessions are exactly what rate-driven slowdowns tend to produce when real policy rates sit too far above the economy’s neutral point for too long.
So, while prices are undeniably too high and inflation is still the problem of the day, the Fed must tread carefully. The last time policy crept above neutral in this new post-GFC world in 2018, the economy immediately buckled and required a dramatic pivot to avoid a downturn. Today, the Fed is not merely above r*; it is dramatically above it, and the economy is already showing signs of strain. If policymakers want to avoid burning down the house, they need to think very carefully about the decisions they make from here.
LAST FRIDAY’S MARKETS
Stocks had a mixed close on Friday as investors bought the dip, reversing the earlier-in-the-week rotation out of growth tech. 10-year treasuries added another 2 basis points as investors grew increasingly concerned that the Fed will be OOO through the new year.
NEXT UP
Empire Manufacturing (November) may have slipped to 5.8 from 10.7.
Fed speakers today: Williams, Jefferson, Kashkari, and Waller.
Later this week we will get some still very important earnings (least of which NVIDIA) along with ADP’s new weekly number, Industrial Production, housing numbers, FOMC Minutes, more regional Fed reports, Retail Sales, and Leading Economic Index. This is, of course, still subject to change in the wake of the recent government shutdown. Download the attached economic and earnings calendars so you can map your way to success in the week ahead.
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