By Howard Schneider

WASHINGTON, (Reuters) – The strong financial position of U.S. households, banks and companies, touted by Federal Reserve officials during the pandemic as a sign of strength, could be a hindrance to fighting inflation. Central bankers are raising interest rates in an economically able economy to bear the cost.

Fed officials outline their aggressive move to tighter money policy. Fed officials claim they are trying to control the economy while not destroying jobs. With higher interest rates slowing down things enough, companies can reduce the high unemployment rate and still avoid any layoffs.

However, this means that the burden of inflation control will fall mainly on capital owners via a slowing housing market, higher corporate bonds rates and lower equity values. A rising dollar would also make it cheaper to imports and encourage domestic producers to keep prices down.

Current and ex-Federal officials, economists note there is no apparent weakness or asset bubble that can be exploited to rapidly reduce inflation. This is not the same as the 2007 hypervaluated housing market or late 1990s internet stocks.

Some measures were able to quickly adjust the Fed’s tighter policy. However, it was spread fairly evenly across many markets. It did not have a catastrophic effect on inflation and consumer spending.

It could happen. Roberto Perli, a Piper Sandler economist, and Benson Durham, a Piper Sandler economist recently calculated that the Fed has tightened financial conditions faster than any other cycle. This should reduce economic growth to “about 1%” by the year’s end. That is half of the economy’s overall trend.

However, the Fed could find it more challenging to wait.

Donald Kohn (ex-Fed vice chair) said that the extent of the problem is dependent on the speed and the degree to which the Fed would like inflation to return to its target of 2% from about triple the current rate.

Kohn stated that the question was “How far can inflation be reduced in the easier part of the cycle”, when growth slows and unemployment increases slightly but not before interest rates rise to the point where the economy crashes. I am not convinced that this will be enough to return inflation to the 2 range. They will need to tighten even more to get that last percentage point. Whether they are able to do so without going into recession remains to be seen.

GOOD NEWS, BAD NEWS

The pieces do not seem to be logically connected.

Fed raised short-term interest rates by 34 of a point in this year. It intends to continue with the same rate at half-point increments at next week’s meeting and then again in July. Expect more to follow.

Although the credit markets have responded by raising home mortgage rates sharply and equity markets falling in stock prices, it is not clear that these actions have resulted in a decrease in demand for or significant declines in inflation.

Although home prices continue to rise, the rate of sales growth may be slower. According to economists, the index dropped 13% in this year. This should be reflected in lower consumer spending. However, the index is roughly at its pre-pandemic levels – not a collapse.

The spreads for corporate credit are increasing, possibly stressing the weaker borrowers. This could also lead to reduced expansion and investment. However, the Fed’s latest financial stability report found that debt service costs remain low. The New York Fed Corporate Bond Distress Index has increased this year but has declined since February when Russia invaded Ukraine. It has also fallen after the Fed has raised its rates for the first time.

The consumer spending is strong. Companies continue to add hundreds of thousands workers per month at higher salaries. Some metrics that the Fed monitors, such as job vacancies rates, are still being monitored.

It’s good news, it keeps the desired narrative of inflation control with no job loss alive.

Bad news: Other than a modest decrease in monthly inflation, it’s difficult to see how the pace of price growth has stopped.

THE ‘WILD CREDIT’

The next week’s policymakers will present new projections on the economy and interest rates. Expect the latest consumer inflation data to be published Friday. It will show that prices are still increasing by over 8% per year, which is a rate not seen since 1980.

Deutsche Bank Matthew Luzzetti (ETR) Chief Economist, estimated that Fed progress on inflation requires financial conditions to tighten even further. This could cause an additional 10% drop in stocks or a 100-basis-point rise in spread between Treasuries investment-grade corporate bond yields and Treasuries.

Luzzetti explained that such a move would “help to reduce inflation pressures and at least theoretically keep open a pathway to a soft land.”

In some ways, the Fed is racing against the clock. As inflation continues to rise, so does the Fed’s ability to control demand. Policymakers should be concerned that this will lead to higher inflation and may need to take a stronger response.

It is not clear how much assistance will be provided through alternative channels, such as improved movement of goods from China and food or other commodities out the Ukraine.

Also, the flow of people into work could help. The flow of workers into jobs could also improve as more people enter the workforce, move for work or retrain.

These are similar to productivity changes and ways that the Fed could help with inflation, without having to borrow more money. It is the central bank’s equivalent of eating a hot meal.

Nathan Sheets, Citi’s Chief Global Economist, stated in a recent interview that Fed policy will continue to work via its usual channels. For example, the slowing housing market could lead to lower furniture and appliance demand.

The adjustment will likely be more difficult due to the magnitude of the inflation shock and uncertainty about how much assistance is coming from other sources.

Sheets explained that “if we don’t see an improvement in these supply shocks…that would mean the measures of financial condition we’re considering will have to tighten potentially significant.” I am not certain about the issue of the slowing down of the rise in unemployment and the reduction in output gap that will be required to lower inflation. It’s the Wild Card.