Longing for “Yesterday” Federal Reserve Abandons Hope of a Soft Landing

The U.S., unlike Europe, has so far avoided stagflation.

Airplane in hangar
Diane Swonk

Diane Swonk

Chief Economist, KPMG US

+1 312-665-1000


“When our troubles seemed so far away…”

I couldn’t get the lyrics to the Beatles iconic song out of my head as I departed from the Kansas City Federal Reserve’s annual Jackson Hole Symposium. Like a relationship gone bad, there was a sense of melancholy and longing for an era when central banks could focus on fostering growth not containing inflation.

Federal Reserve Chairman Jay Powell set the tone for the conference with a brief, eight minute and thirty-four second speech. The cadence of his speech slowed to match the somber tone of his message. The Fed was about to engineer a recession to eradicate the risk of a more entrenched inflation. 

Since March 2022, Powell has danced around the topic, using words like “soft-ish” when referring to the “narrowing path to a soft landing.” In Jackson Hole, he buried those hopes with comments that were direct. His tools are limited and work on demand instead of supply. That means hiking rates until growth slows below the economy’s potential to grow and demand comes more into balance with supply. The Fed now sees some “pain,” or a rise in unemployment, as inevitable; it intends to trigger a recession. 

The increase in the unemployment rate we saw in August doesn’t get us where we need to go. The unemployment rate rose as more people entered the labor force than could get new jobs, not because they suddenly lost jobs. That is good as long as it alleviates the cost pressures in the labor market but it hasn’t. 

Another problem is seasonal adjustment. Specifically, the number of unemployed held at the levels of July before seasonal adjustment in August. That means the increase in the supply of workers could be more of a fluke than the start of a new trend.

The choice to trigger a more pronounced slowdown is not easy but represents the lesser of two evils. Either the Fed pushes growth below the economy’s potential and pushes up the unemployment rate today, or we could endure a more prolonged inflation or worse, stagflation; that would mean an even deeper, more scarring recession would be needed to derail inflation down the road.

This edition of Economic Compass provides a look at the themes that emerged from the conference, what they tell us about rate hikes, recession and the world that emerges from the pandemic. A recession alone will not eradicate the war for talent and avert larger labor market shortages. We could be moving into an era in which workers have more leverage.

Economy Stalls 

Real GDP growth fell at a 0.6% pace in the second quarter, a slight upward revision to initial estimates for growth. Consumer spending is where the bulk of the strength was, as strong employment gains helped offset the bite from inflation and higher rates. Housing collapsed and fell into recession territory, business investment stalled and the trade deficit improved with a temporary rebound in exports. Government spending continued to fall with the end to pandemic aid. State and local governments have been slow to spend reserves rebuilt during the pandemic. 

Prospects for the third quarter are better. Real GDP growth is expected to rebound at a 1.1% rate. Consumer spending is expected to benefit from a tailwind of robust employment gains and a downdraft in energy prices. Housing continues to be hammered by high rates and low affordability. Business investment is poised to catch up with an uncoiling of supply chain delays and the trade deficit is expected to narrow with another pick-up in exports. Government spending is expected to post modest gains, as state and local governments implement tax holidays and issue tax rebates. 

Fed Continues to Hike. The Federal Reserve is expect to hike rates another 1.5% by year-end. That should amplify a tightening of credit conditions triggered by reductions in the Fed’s bloated balance sheet. The bulk of those are scheduled to hit after Labor Day in September. The Fed has concluded that it needs to cause a mild but prolonged recession to derail what has fast become a much more global surge in inflation. 

The low-hanging fruit that globalization offered in terms of cheap labor and inexpensive goods has been plucked.

Four Themes

#1. Central banks exist to foster price stability. Central bankers are forced to make the tough decisions that elected officials find untenable. Arguing that a rise in unemployment is necessary to cure a rise in inflation is a no-win proposition. That is why central bankers are supposed to act independently.

That said, raising rates is political and fraught with risk. Many who have raised rates aggressively are now facing death threats to themselves and their families. The political backlash is real. 

The pressure to back off from rate hikes will intensify once employment actually stalls. That will take time, especially given the enormous gap between job openings and those actively seeking work; there are now two job openings for every job seeker. 

The Fed wants to avert a repeat of the 1970s. Many things have changed since then. Those changes, coupled with lags in when rate hikes affect the economy, increase the risks of overshooting; a more  prolonged recession could ensue.

#2. Inflation is inertial. This is perhaps one of the least understood but most important aspects of inflation. Long periods of high inflation tend to reshape consumer behaviors, which feed inflation even as the economy slows.

Workers demand that wages are indexed to measures of inflation, while firms bake price hikes into their strategies to preserve profit margins. This is known as a wage-price spiral and fed the stagflation of the 1970s. 

There is more evidence of such a spiral emerging in Europe, which is already suffering from stagflation, but it remains a top concern for the Federal Reserve. Recent measures of inflation expectations in the U.S. have come down in response to the fall in prices at the gas pump but remain elevated.

The Fed will need to see a sustained improvement in measures of inflation expectations to feel comfortable that inflation momentum has been derailed. Again, the risk is that by the time the Fed realizes that, we may have already suffered more pain than necessary. 

#3 History is a guide. History is littered with examples of central banks that paused before inflation had been tamed. In response, inflation expectations became unmoored. A vicious cycle of eroding living standards, falling profit margins and elevated layoffs ensued.

The Fed fears we could be one supply shock away from that occurring. Everything from a surge in extreme weather events to the war in Ukraine, which are stressing the energy grid, to China’s zero COVID policy continue to disrupt supply chains.

Europe may have already crossed into this territory. Surveys of those in position to make decisions on both wages and prices, including c-suite executives, have moved their expectations for inflation up even faster than those in the overall population.

Goods inflation in the U.S. has begun to cool; that includes prices at the gas pump. The concern is service sector inflation, which is more dependent on labor costs. Wages and earnings have begun to plateau but not cool, while productivity growth has plummeted. 

In response, unit labor costs surged 9.3% from a year ago in the second quarter, the fastest pace since 1982. Persistent wage gains in the face of tepid productivity could set a floor for how low inflation can go without more aggressive rate hikes. 

Productivity growth has fallen in recent quarters and could remain weak for a longer period of time. The initial gains from the pivot to working from home are diminishing. People have more to do with their lives than they did in response to initial quarantines. They can go out or just enjoy the simple pleasures of gathering with friends and family again.

Young workers are losing the intangibles: learning soft skills, experiencing mentoring and encountering the engagement that acts as a glue binding workers to their jobs and boosting their commitment and productivity.

Acute staffing shortages and high turnover rates are eating into the morale and productivity of frontline jobs. Churn and a high number of people out sick each month add to the stress of working and dealing with staffing shortages. In August alone, the ranks of those out sick and unable to work were 60% higher than any month prior to the pandemic.

Hence, the conclusion by the Fed that the current 3.7% unemployment rate is unsustainably low. The Fed now believes the noninflationary rate of unemployment - the rate at which inflation stabilizes - is between 4% and 5%. To reduce inflation, unemployment would need to move above that range.

The only offsets are technological advances, such as AI and automation, which could help alleviate worker shortages. Automation without the skilled staff to fix breakdowns is one of many hurdles. The problem is that technological shifts tend to take years, not days or hours, to take root. Many of the ways we leveraged technology to keep the economy running during initial quarantines were already in place and well understood.

The ultra-low inflation and interest rate environment of the last forty years has increased market concentration among a few large, tech-savvy firms. The bulk of productivity gains those companies enjoy are not shared across the economy. That creates hurdles to broader adoption of technologies. 

Profits of large, publicly traded companies hit their highest levels since 1950 in the first half of 2022; their market power enabled them to pass rising costs onto customers. Smaller and mid-sized companies were less able to pass along those increases. 

The largest retail and tech firms have paused or canceled plans to expand. Some have announced layoffs but not enough to derail employment. Most of those shifts reflect the pivot in spending from goods to services. 

Our own analysis suggests that unemployment will need to hit 5.5% before inflation returns to the Fed’s 2% target.

#4. An era of scarcity. There is a concern that we have moved from an era of abundance to one of scarcity. The low-hanging fruit that globalization offered in terms of cheap labor and inexpensive goods has been plucked. That helps workers who have been sidelined by offshoring but only if they are able to sustain wage gains that give them a leg up on inflation.

Protectionism and nationalism were on the rise ahead of the pandemic. Large, overarching trade deals were abandoned for smaller, more regionalized trade deals, while tariffs and quotas picked up. The pandemic and war highlighted the fragility of global supply chains and intensified the desire for countries to be more self-sufficient, regardless of cost. 

Efforts to subsidize strategically important industries picked up, while many countries started to restrict their own exports. The speed with which businesses were forced to pull out of Russia in the wake of its invasion of Ukraine was breathtaking. That is intensifying the attention that firms must pay to where and with whom they do business. Sourcing based on where production is cheapest is no longer a sufficient goal.

This is before the disruptions to trade and supply chains triggered by China’s zero COVID policy and climate change. Droughts, fires, floods and blistering heat waves are undermining crop yields, stressing the power grid, destroying property and making it untenable for workers to live and work in some places. It is tough to produce among rolling power outages and blistering heat. The incidence of fatalities due to heat exhaustion is on the rise.

This is at the same time that global labor supply is constrained. The aging of the baby boomer into retirement, a surge in early retirements and a dearth of young people to replace them are all compounding labor shortages. 

Add higher fatality and infection rates, and it is little surprise that growth in the labor force has stalled. The incidence of long COVID is estimated to be sidelining two to four million workers today. Studies on the effects of long COVID indicate that they can show up a year after a mild infection. That suggests that more prime-age workers could be sidelined in the years to come, given the high level of infections we decided to accept.

A rise in immigration could alleviate those shortages but requires major reforms. Few will come to learn, work and pay taxes here without guarantees that they can stay. Legal immigration has been on a downtrend to the U.S. since 2016 and continues to suffer from backlogs due to the pandemic.

The world thereafter could be one of shorter business cycles, punctuated by inflation.

The Fed's Reaction Function

The fed funds rate is currently trading at between 2.25% and 2.5%. That is a rate the Fed considers close to neutral; it holds inflation constant.

The Fed will release new estimates of what officials think the terminal rate on the fed funds rate will be after the September meeting. Most participants are expected to put the terminal rate close to 4%. That is what we have in our forecast. 

Our own analysis suggests that unemployment will need to hit 5.5% before inflation returns to the Fed’s 2% target. We do not expect the Fed to cut rates until late 2023; that is much later than many in financial markets hoped.

The Fed is remarkably confident that reductions in its balance sheet, or quantitative tightening (QT), will be operating largely in the background and not trigger any additional problems. Officials have been transparent on what they intend to do and are monitoring financial markets daily from their trading operations at the Federal Reserve Bank of New York. 

Color me skeptical. No one knows for sure how much reductions in the Fed’s balance sheet will amplify short-term rate hikes. Former employees of the New York Federal Reserve Bank, whose job it was to oversee those very operations, are split on what they think might occur; so are academics. 

Some believe all the effects of the Fed’s announced program are already priced into financial markets. Others worry the balance sheet could have a larger impact on rates.

Spillover Effects

A period of ultra-low rates likely papered over a lot of financial sins. In the early 2000s, low rates masked the dangerous levels of debt households were taking on to buy homes. Household and firm balance sheets are in much better shape than they were back then. The problem is sovereign debt, which has exploded.

Developed and developing countries added to the debt they accumulated in the wake of the global financial crisis to deal with the pandemic. The flight to safety associated with the war in Ukraine and commitment to rate hikes by the Fed have triggered a surge in the value of the U.S. dollar on international exchange markets. Those shifts effectively exported inflation and intensified the pressure to raise rates abroad. 

Developing and some developed economies are struggling to service the interest expenses on those debt payments as well as principal payments. This is at the same time they are being forced to issue more debt to subsidize the basics of food and energy.

The world thereafter could be one of shorter business cycles, punctuated by inflation. That is a very different world from the slow moving, more predictable world we left. Business models based on low rates and more stable financial market conditions will have to adapt and hedge for more frequent shocks. 

Automation and AI are both expected to fill the gaps left by labor shortages. One of the largest shifts will be in how workers are treated and to what extent technology enhances productivity and stronger wage gains.


Bottom Line

Much like Paul McCartney’s iconic song, our troubles look like they’re here to stay. The shadow of inflation is hanging over us. Central bankers may need a place to hide away as they execute on policies to tame it.

That is a hard message to deliver. Then again, so was the chill of the last four decades and how it left us with an abundance of workers relative to jobs. Globalization and the low inflation/low interest rate environment it triggered is too often viewed through the prism of rose-colored glasses. The reality was much harder. Workers displaced through globalization seeded divisions and the mistrust of institutions, including large employers.

The situation we are in is not easy and means we will endure more change. With change, there is opportunity. Perhaps that is the most important message of the Beatles hit song. I believe in what yesterday can teach us, but harbor no illusions about the world we left; it was devastating to large swathes of our population who are justifiably angry. McCartney’s character in the song wouldn’t be longing for yesterday if he had treated his relationship with more care, instead of “a game to play.”


Economic Forecast—September 2022

  2021 2022 2023 2021:4(A) 2022:1(A) 2022:2(A) 2022:3 2022:4 2023:1 2023:2 2023:3 2023:4
National Outlook
Chain Weight GDP1 5.7 1.6 0.3 6.9 -1.6 -0.6 1.1 0.3 0.1 0.0 0.7 0.7

Personal Consumption

7.9 2.4 0.9 2.5 1.8 1.5 1.7 1.1 0.4 0.5 0.7 1.0

Business Fixed Investment

7.4 4.3 1.7 2.9 10.0 0.0 2.5 4.5 1.7 0.8 0.0 0.4

Residential Investment

9.2 -10.1 -13.6 2.2 0.4 -16.2 -31.0 -24.3 -13.1 -3.1 3.7 4.3

Inventory Investment (bil $ '12)

-33 96 37 193 189 84 56 56 59 40 34 15

Net Exports (bil $ '12)

-1276 -1433 -1413 -1341 -1536 -1465 -1358 -1371 -1398 -1413 -1419 -1421


4.5 6.9 3.2 22.4 -4.8 17.6 10.5 0.6 0.4 0.9 2.2 3.6


14.0 8.8 1.5 17.9 18.9 2.8 -4.6 1.8 3.1 2.1 2.1 2.4

Government Expenditures

0.5 -1.5 1.4 -2.6 -2.9 -1.8 -0.5 1.6 3.3 1.2 1.3 1.4


0.6 -4.4 1.6 -4.4 -6.8 -3.9 -1.6 1.7 6.1 0.7 0.6 0.4

State and Local

0.4 0.2 1.3 -1.6 -0.5 -0.6 0.2 1.5 1.7 1.5 1.8 2.0
Final Sales 5.3 0.9 0.6 1.5 -1.2 1.3 1.7 0.3 0.1 0.3 0.8 1.1

GDP Deflator

4.2 7.2 4.2 7.2 8.1 8.9 5.2 6.1 3.9 2.6 2.6 2.3


4.7 8.0 3.7 7.8 9.2 10.5 5.2 5.0 3.0 1.3 2.4 2.8

Core CPI

3.6 6.1 4.0 5.6 6.5 6.7 6.7 4.8 3.8 2.9 2.6 2.5
Special Indicators

Corporate Profits2

21.0 3.4 -2.9 21.0 12.6 8.1 3.0 3.4 3.4 -4.1 -2.2 -2.9

Disposable Personal Income

2.3 -5.4 2.7 -4.5 -7.8 -0.6 0.8 1.3 2.1 5.0 5.0 5.0

Housing Starts (mil )

1.61 1.54 1.20 1.68 1.72 1.66 1.44 1.33 1.21 1.21 1.19 1.20

Civilian Unemployment Rate

5.4 3.7 4.4 4.2 3.8 3.6 3.6 3.7 3.9 4.2 4.6 5.0

Total Nonfarm Payrolls (thous)3

6169 1181 -314 1759 1720 1261 1281 461 -27 -331 -433 -465
Vehicle Sales

Automobile Sales (mil )

3.0 3.1 3.6 2.7 3.0 3.0 2.9 3.4 3.7 3.9 3.5 3.3


2.1 2.1 2.4 1.8 2.0 2.1 2.0 2.3 2.4 2.5 2.3 2.2


0.9 1.0 1.3 0.9 1.0 0.9 0.9 1.1 1.3 1.4 1.2 1.1

LtTrucks (mil )

11.3 10.8 11.0 10.6 11.2 10.6 10.6 10.9 10.7 10.9 11.2 11.1


8.8 8.5 8.6 8.2 8.8 8.3 8.3 8.6 8.4 8.5 8.8 8.7


2.5 2.4 2.4 2.4 2.4 2.3 2.3 2.3 2.3 2.4 2.4 2.4

Combined Auto/Lt Truck

14.3 13.9 14.6 13.2 14.2 13.5 13.5 14.3 14.4 14.8 14.7 14.4

Heavy Truck Sales

0.5 0.5 0.4 0.4 0.5 0.5 0.5 0.4 0.4 0.4 0.4 0.4
Total Vehicles (mil ) 14.8 14.4 15.0 13.7 14.7 14.0 14.0 14.7 14.8 15.2 15.1 14.8
Interest Rate/Yields

Federal Funds

0.1 1.7 3.9 0.1 0.1 0.8 2.3 3.5 3.9 3.9 3.9 3.8

10 Year Treasury Note

1.4 2.8 3.3 1.5 1.9 2.9 3.1 3.4 3.5 3.4 3.3 3.2

Corporate Bond BAA

3.5 5.0 5.6 3.4 4.0 5.1 5.4 5.6 5.7 5.7 5.6 5.6
Exchange Rates
Dollar/Euro 1.18 1.07 1.06 1.14 1.12 1.06 1.04 1.05 1.05 1.06 1.07 1.07
Yen/Dollar 109.8 128.3 126.7 113.6 116.4 129.7 134.0 133.0 131.2 128.8 125.4 121.4
1In 2021, GDP was $19.4 trillion in chain-weighted 2012 dollars.
² Corporate profits before tax with inventory valuation and capital consumption adjustments, quarterly data represents four-quarter percent change.
³ Total nonfarm payrolls, quarterly data represents the difference in the average from the previous period. Annual data represents 4Q to 4Q change.
Quarterly data are seasonally adjusted at an annual rate. Unless otherwise specified, $ figures reflect adjustment for inflation. Total may not add up due to rounding.