Frankfurt The very experienced and distinguished monetary politician Bill Dudley praises the recent measures taken by the US Federal Reserve. “It has now become a bit more realistic,” he says in an interview with the Handelsblatt. Fed President Jerome Powell finally gave up his reticence at the press conference after the meeting on Wednesday and put the fight against inflation in the foreground.
Dudley was head of the New York regional Fed from 2009 to 2018 and was one of the most influential economists in the country at the time. During his tenure, Dudley did not appear as a “hawk”, ie as a supporter of tight monetary policy.
Most recently, however, in line with other well-known economists such as Larry Summers and Mohamed El-Erian, he had harshly criticized the Fed and accused it of reacting too late to the rise in inflation. “It’s too late, and monetary policy has been way too loose for a long time,” Dudley reiterates now. But now he hopes that the central bank will regain its footing.
The Fed raised interest rates by 0.75 percentage points on Wednesday to a range of 1.5 to 1.75 percent – and announced another hike of 50 or 75 basis points in July. Dudley sees this as the central bank’s determination to keep inflation expectations under control. So far, he notes, it has succeeded in doing so: “The Fed has retained its credibility.”
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“Powell said a lot of right things, like that low inflation is also important for a healthy job market,” Dudley continues. In his opinion, however, the Fed chair should have admitted that bringing inflation under control will also cause “pain”. “I always say, ‘Either a little pain now or a bigger pain later,'” he explains.
Experiences with recession after high inflation
Dudley draws a comparison with the 1970s, when inflation rose sharply because the Fed didn’t fight it – until legendary Fed Chairman Paul Volcker brought inflation under control but had to accept a severe recession to do so.
The markets are still dominated by concerns about the negative effects that aggressive interest rate hikes will have on the economy. Dudley is also pessimistic that a “soft landing” can still succeed, i.e. catching inflation without a recession.
The currency watchdogs also presented new inflation forecasts on Wednesday. Accordingly, they expect inflation to subside to just above the target of two percent by 2024 and unemployment to rise to a good four percent.
According to Dudley, these projections are no longer as unrealistic as previous predictions, but are still very optimistic. “If Jerome Powell can do that, it would be a huge achievement,” says Dudley, “but the odds are slim.”
According to him, there has always been a recession in the USA when unemployment has risen by half a percentage point – and according to the latest forecast that would be exactly the case: from the current 3.6 percent to 4.1 percent.
Dudley also doesn’t believe that a reported unemployment rate of around 4 percent would actually be high enough to dampen inflationary pressures. “The Fed has always underestimated how tight the job market really is,” he says. He also sees a big difference here compared to Europe: Because people are laid off more quickly in the USA in a recession, the labor market can, conversely, overheat more quickly, because more people then have to be reintegrated first when there is an upswing.
So the bottom line is that it’s possible that the Fed will catch the high rate hikes in the future – but that process is unlikely to be painless. “Without some leeway in the labor market, it won’t work,” he says. “If the Fed had reacted better, then we should already have 4 percent rather than 3.6 percent unemployment.”
So how much do interest rates have to rise overall? Where is the much-discussed “neutral” interest rate, at which the economy could be in equilibrium—without inflation and recession? Dudley laughs: “Certainly not at 1.6 percent,” from that point of view the Fed’s interest rates are still far too low. But he also admits that this level can only be estimated and not directly determined: “The neutral rate can be three percent or five percent. The truth is: we don’t know.”
The comparison to Europe
Dudley stresses that inflation in the euro area is more focused on energy prices than in the US. He is very worried about the effects of the war in Ukraine – he is explicitly addressing Germany: “The government may have to make difficult decisions in winter when it comes to whether gas can be used for heating by citizens or for industry.”
He sees the most difficult problem for the European Central Bank as preventing bond yields from drifting apart between less and more heavily indebted euro countries, such as between Germany and Italy. As far as it is legally possible, he believes that the central bank should intervene in the market. The differences in yields, known as spreads in technical jargon, have already increased significantly in recent weeks.
>> Read here: What can the ECB do against crises? The six most important answers to fears about the euro zone
Looking further into the future, Dudley already sees tendencies that would speak in favor of higher real interest rates, i.e. the level of interest rates minus inflation. The “excess savings”, which was used to justify the very low returns on capital for a long time, will be reduced if a large generation worldwide retires and then no longer saves as much, while smaller generations follow. On the other hand, there is an increasing need for investment due to climate change, also as a result of the war.
But Dudley doesn’t think that necessarily means inflation will be higher in the long run. He says: “If inflation rises, the central banks can do something about it. You just have to do it. In the end, inflation is a monetary phenomenon.”
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