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The Federal Reserve Faces a Complex Challenge as Markets Wait for a Solution

Traders in the stock market don’t seem to care what’s behind the recent disinflation. Enlivened by dreams of an artificial intelligence bonanza, they have been bidding up the prices of big tech companies like Nvidia, Apple, Meta (Facebook), Alphabet (Google), Tesla and Microsoft since the fall. As I wrote recently, cruise lines like Carnival, Royal Caribbean and Norwegian Cruise Line have been booming on pent-up demand from consumers eager to see the world in seaborne comfort.

At the moment, for the markets, the sky seems to be the limit.

And yet, I worry.

The reasons for the decline in inflation aren’t merely of academic interest. If, for example, the Fed’s interest rate increases have not had much impact on the overall economy so far, that could simply be because they famously operate with “long and variable lags,” and they may yet bite — even if inflation has been coming down for other reasons.

Some painful effects are already discernible, however. High credit card rates are adding to consumer distress. Bond losses caused by rising rates have contributed to regional bank weakness. Costly mortgages have hurt housing and commercial real estate, while the work-from-home migration has shriveled office occupancy. How long that will last is anyone’s guess.

Interest rate increases this rapid and this large typically “lead to recessions,” Ian Shepherdson, chief economist of Pantheon Macroeconomics, warned in a presentation to clients this month. Credit tightening for small businesses caused by distressed regional banks hasn’t helped, either. Mr. Shepherdson isn’t saying there will definitely be a formal recession, but he said slower growth was coming.

The majority opinion on Wall Street is still that there will be a recession in the next 12 months, a Wall Street Journal survey this month showed. But because of the onslaught of data indicating that the economy remains in growth mode, many economists are lowering the odds of a recession happening, and expect that if one occurs, it will be mild.

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