The Fed’s Dilemma…

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• Inflation’s impact just won’t let up, and the Fed has its work cut out for it in trying to tame it. There’s a tightrope walk between maintaining economic stability and lurking recession.
• A soft landing is more likely than it was a year ago, but recession risks remain real: Any economic shock — be it from labor market disruptions or unexpected global events — could still send the economy into a tailspin.
• Meanwhile, the growing U.S. deficit heightens the pressure: While not yet at crisis point, it’s far from sustainable long-term. Fiscal policy and political gridlock could expand the deficit, driving up bond yields and exacerbating the Fed’s challenge to maintain inflation and growth.

Jason Furman, Harvard professor and former Chair of the Council of Economic Advisors, is no stranger to navigating economic uncertainty. And boy, is he the man for the hour.

As one of the most respected voices in modern economics, Furman is primed to share insights on persistent inflation, the Federal Reserve (Fed)’s complex balancing act, and the long-term risks of rising government debt.

At a time when central banks are struggling to rein in inflation without derailing economic growth, Furman gives a sober analysis of why traditional monetary tools may not be enough. Just look at the inflation data: “When we have a bad month, it’s really bad,”Furman says. Headline numbers show improvement, but underlying pressures remain uncomfortably high. Recession risk and inflationary pressure together paint a picture of an economy caught between a rock and a hard place.

And he knows how precarious the Fed’s current strategy really is. If it’s forced to keep interest rates higher for longer than markets expect — despite the growing calls for rate cuts — it’ll be clear why. And while Furman acknowledges the potential for a soft landing, he’s wary of a bumpy ride.

As if inflation and interest rates weren’t enough to worry about, Furman gives us one more thing: the looming threat of unsustainable government debt. Expect higher deficits as a result of rising borrowing costs and political gridlock, as fiscal policy causes headaches for both investors and policymakers.

Furman’s most crucial insights — from why inflation is proving so stubborn to how China’s economic recovery could send shockwaves through global markets — follow.

Inflation: Something’s gotta give, but it just ain’t letting go

Inflation’s decline has been slower and more erratic than expected. While some headlines celebrated the drop in inflation to its lowest levels since the pandemic, Furman cautions that core inflation — a key metric for predicting future inflation trends — is proving to be more resilient.

“The headlines were talking about the lowest inflation rate of the whole inflationary period. But every hundredth of a miss is a tenth of a miss at an annual rate,” Furman says. Even a slight deviation in the core inflation rate could amplify the problem big time, potentially complicating the Fed’s path forward.

The core issue? Inflation is “stickier” than many analysts expected, Furman explains. Labor markets are looser than they were pre-pandemic, but they continue to apply upward pressure on prices, preventing inflation from falling back to pre-crisis levels. “When we have a bad month, it’s really bad. When we have a good month, it’s just normal,” he says.

Labor market’s influence on inflation

One of the reasons inflation has been slow to decline is the continued strength in the U.S. labor market. While wage growth has slowed compared to the height of the post-pandemic recovery, it’s still robust enough to support consumer spending, which in turn is keeping prices elevated.

“The labor market is looser than it was in 2019 by a variety of different measures,” Furman says, but he cautions that this doesn’t mean inflation will drop quickly. The key issue is that while labor markets have eased, they haven’t weakened to the point where they put substantial downward pressure on prices. As a result, inflation could remain higher than the Fed’s target for longer than expected.

A heckuva dilemma

One of the most pressing macroeconomic questions is how the Fed plans to balance the twin risks of inflation and economic recession. There’s a very fine tightrope walk between maintaining credibility and managing inflation without triggering a recession.

The Fed may well be forced to cut interest rates more slowly than markets anticipate, with a faster decline reigniting inflationary pressures. “The neutral rate is a real thing,” Furman says, “but we don’t quite observe it. We don’t quite know what it is.” Such uncertainty makes the Fed’s task even more complicated, as it tries to gauge the impact of each rate decision.

But if the Fed moves too aggressively with its rate-cutting exercise, inflation may morph into a real threat: “There’s just this big question that we don’t know the answer to, which is what is the neutral rate today?”

Mission: Fed transparency

As it walks such a fine line, the Fed focuses on what it can control: its communication strategy.  Furman acknowledges that it’s recently moved towards greater transparency in a bid to manage market expectations and anchor inflation expectations. But even if it helps to be open, is it now too open? Furman reckons it may have gone too far, sometimes causing market volatility.

“Everyone I know is just so negative about the Fed’s transparency,” Furman highlights. While it’s a strategy designed to build credibility, it can lead to overreactions in the market. Investors hang on every word from Fed officials, sometimes misinterpreting short-term data shifts as signals for long-term policy moves. Furman’s take? “You know, a lot of people are profiting off it,” but that doesn’t mean the volatility is desirable.

However, he acknowledges that the Fed’s transparency is more good than bad overall, particularly in anchoring inflation expectations. It could just do with dampening the noise from time to time to regain some clarity. “They don’t know what the neutral rate is. They don’t know how many percentage points above neutral you should be,” he says. But it’s always difficult to give precise guidance in an uncertain environment.

Data dependence shapes policy decisions

One of the hallmarks of recent Fed policy has been its data-dependent approach. The idea behind data dependence is that the Fed will adjust its policy based on the latest economic data, rather than sticking to a preset path. While this allows the Fed to react to real-time developments, Furman points out that this can sometimes lead to increased volatility as markets respond to every new data point.

“We’ve had revisions to employment and GDP data: you get a slightly different picture than if you were basing policy just on the actual release,” Furman explains. He suggests that while data-driven policy is crucial, it requires a steady hand, and over-reliance on short-term numbers can create more noise than signal.

Furman advocates for a broader perspective, arguing that while data revisions are normal, the Fed should focus on long-term trends rather than reacting too quickly to minor data fluctuations. “Look at the 10-year rate: It moves around a lot,” he says. “These data points come out, and it can move up 5, 10, or 15 basis points — or down by the same amount.

The point underscores the challenge of balancing short-term reactivity with long-term stability.

Debt just keeps on growing and growing

Meanwhile, the long-term risk of growing U.S. government debt is ever-present. While he doesn’t see an immediate crisis, Furman points out that rising interest rates are already putting pressure on the federal budget, and this pressure could increase significantly in the coming years.

“When the 10-year yield is around 4%, it doesn’t really send me off panicking,” Furman notes, but adds that the growing debt is still unsustainable in the long term. He anticipates that future administrations — especially with rocketing debt-servicing costs — will need to bite the bullet once and for all.

Political gridlock might not help either: “Divided government can do plenty,” he says. “You get your stuff in exchange for me getting my stuff, and the union of everyone’s stuff might even be bigger.” Furman’s view is that fiscal policy could end up being even more expansive in the coming years, exacerbating existing challenges around inflation and debt management.

It’s ultimately all about the deficit

Furman stresses that the U.S. federal deficit will play a critical role in shaping financial markets in the coming years. He notes that while deficits have long been a concern, the current fiscal outlook is more worrisome due to the combination of these high debt levels and rising interest rates.

“We’re getting more manufacturing structures built,” Furman says, “but that’s because of the nature of fiscal policy.” The issue, however, is that this increased spending could crowd out other investments and eventually put upward pressure on interest rates. This would create a feedback loop where higher rates increase the cost of borrowing, leading to further fiscal strain.

The angle from the East: Global economic repercussions

Don’t forget to look to China, and how its economic recovery could affect the global economy. Furman argues that while the behemoth’s stimulus efforts are a welcome development, they won’t fully solve the country’s deeper structural challenges.

A ripple effect on global markets is likely, particularly in commodities. “China should stimulate, and now they’re finally doing it,” he notes. But while global commodity prices in the short term will send commodity prices up, the stimulus doesn’t address the long-term demographic and productivity issues that China faces.

Global investors should be wary of volatility in commodity prices and additional inflationary pressures in markets heavily reliant on Chinese demand.

Geopolitics and the future of the U.S. dollar

Amid rising geopolitical tensions, Furman also touches on the role of the U.S. dollar in global markets. He suggests that while the dollar remains dominant, its future as the world’s reserve currency isn’t guaranteed.As countries like China and Russia explore alternatives to the dollar in global trade, the U.S. could face increasing pressure to maintain its currency’s status.

“The dollar is the denominator of most global trades and FX transactions in the world,” Furman explains. But as the global economy becomes more fragmented, Furman warns that transitioning away from the dollar won’t be an orderly process. This shift could introduce significant volatility in currency markets and create new challenges for global investors.

Prepare for uncertainty…and anything

The economy continues to stumble between continued inflation and an outright downturn — with any number of factors potentially throwing it off balance.

“We’re probably having a soft landing,” Furman says, “but we’re not all the way there yet.” The Fed continues to weigh the risk of tightening too much against the risk of doing too little. The buzzword of the moment is uncertainty.

Investors and policymakers alike need to be prepared for multiple potential outcomes — from higher-than-expected inflation and increased geopolitical tension disrupting global markets to further Fed rate hikes or cuts.

“There’s still plenty that could go wrong,” Furman says. “Investors need to stay nimble.”

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.