After ten consecutive rate hikes, the Fed took a breather last month, which raises a multi-trillion-dollar question: Is the Fed’s pause a temporary “temperature check” or a change in rates trajectory?

The question isn’t an easy one—not because the Fed’s decisions are arbitrary, but because the mandates that govern its policy are in conflict with each other.

And it’s entirely possible that engineering a recession is the Fed’s best shot to align those objectives today.

The most aggressive rate hikes in decade

In light of post-Covid inflation, the Fed launched the most aggressive series of rate hikes since the end of the 1970s. In just over a year, it raised rates from 0.25% to 5.25%.

Inflation responded, dropping from 9% to just above 4%. And while this is still double the Fed’s target, the decline was enough for the Fed to put further hikes on hold in June.

At last month’s press conference, Fed Chair Jerome Powell said the pause would “allow the Committee to assess additional information and its implications for monetary policy.”

That makes a lot of sense because monetary policy tends to have a lag effect. And considering the pace of this hiking cycle, the Fed wants to see its full impact before taking the next step.

But whatever Powell decides, he is likely to have to give up one side of the famed “dual mandate.”

Dual mandate: the Fed’s playbook

The Fed’s mandate has two official objectives: low unemployment and low inflation.

While these goals sound simple, achieving both at the same time is difficult. This is because satisfying one end of the mandate always threatens to upend the other.

If the Fed raises rates to stamp out inflation, it can spark a recession. But if it lowers rates to improve the economy, it can cause inflation. The Fed, therefore, has to walk a tightrope between these two goals.

Today, unemployment is low and inflation is falling. So, what happened? Did the Fed get lucky and manage to achieve both goals at once? Headlines might tell us the answer is yes.

But digging deeper, inflation is a stickier problem than it first appears.

Inflation—the core issue

The headline rate of inflation, known as the Consumer Price Index (CPI), is falling. But other important benchmarks of the cost of living that central bankers pay attention to are not.

For example, the Fed’s favorite way to measure inflation is known as core PCE (for Personal Consumption Expenditures). It uses a different methodology from CPI, but most important, it excludes volatile elements like food and energy prices—which can distort the real picture of inflation.

To think about the difference between CPI and core PCE, imagine you are a teacher trying to predict the average student grades for an upcoming exam.

There is a group of students with a rep for partying. If there is a party the night before the exam, you anticipate they will all fail. But if there is no party, you expect them all to do well.

Including these volatile students in your prediction would be like CPI, while excluding them would be like core PCE. Both can be valuable—but the core measure would be a better gauge of real changes in student performance over time.

Now, back to the economy. Since December 2022, CPI has fallen by more than 2%. Core PCE, however, remains just as high as it was then.

Prices are stabilizing, but are not where they need to be. Core inflation remains stubbornly high at double the Fed’s target. To bring it down, the Fed will likely need to increase interest rates even more.

So far, rate hikes haven’t done too much damage to the economy. At 3.7%, unemployment is still very low. Future rate hikes, however, can be much more destructive.

“Crush demand and slow down the economy”

Economists are ringing alarm bells that the Fed might have to fix inflation at the economy’s expense.

Torsten Slok, the chief economist at Apollo Global Management, put it bluntly. “The only way to get inflation down to 2% is to crush demand and slow down the economy in a more substantial way.”

But wait, wouldn’t a recession cause job losses? And isn’t half the Fed’s mandate to keep unemployment low?

While this is true, the Fed cares more about beating inflation than about keeping jobs.

During the 1980s, Fed Chair Paul Volcker ruthlessly raised rates to bring down inflation. While he ultimately succeeded, the unemployment rate peaked at nearly 11%.

Some commentators have suggested raising the inflation target slightly. Their logic is that it will be less painful to bring the target to inflation than it would be to bring inflation to the target.

But the Fed understands that doing so would destroy its credibility. People expect inflation to stay low in the long term because they rely on the Fed to control inflation, no matter what.

At each press conference, Powell has reaffirmed the Fed’s commitment to hitting the 2% target. Because raising the target would be the Fed’s only escape hatch, a recession looks likely.

You might not agree that curbing inflation is more important than keeping your job. But the Fed has made its position clear.

Turbulent times to come

The Fed’s recent hiking pause is just that—a pause. Rate hikes will only truly stop when the job is done. And with inflation still double the target rate, we’re not there yet.

The pause will allow the Fed to survey the impact of rate hikes so far, including the banking turmoil from earlier this year. But with the economy robust, the pause is unlikely to last.

In theory, the Fed balances its dual mandate of low inflation and low unemployment. In practice, the Fed has expressed a willingness to do what it takes to conquer inflation, regardless of economic consequences.

Despite what the headlines say, we aren’t out of the woods yet.