The US inflation rate will inevitably have at least an “8” in front of it and perhaps even a “9” as the flow-on effects of the responses to the invasion and Russia’s countermeasures start to show up.
In the circumstances the Fed ought to be going hard. It should have gone hard much earlier. A 50 basis point rate rise (which many in the markets had expected until very recently) and an immediate start to running down the $US8.9 trillion ($12.2 trillion) of assets in its balance sheet and removing liquidity from the system would be a good,if belated start.
Instead it appears likely to retain the same cautious approach it has maintained even as inflation had clearly broken out last year.
The Fed,and other central banks,do face some invidious choices because much of the spiralling of inflation rates is already baked into corporate and consumer expectations.
The fiscal splurges in response to the pandemic have left consumers awash with cash and given companies still struggling with malfunctioning supply chains a rare opportunity,which they are seizing,to raise prices even as continuing pandemic-related shortages of labour,particularly cheap labour,is creating wage inflation.
The economic fallout from the war in Ukraine and the trajectory of monetary policies throughout the Western world threaten what economists are now describing as “stagflationary winds,” although those winds could easily morph into a gale offull-blow stagflation,or sharply falling economic growth rates even as inflation remains at levels not seen in decades.
The oil price hike alone will depress economic growth relative to what it might otherwise have been while feeding into higher inflation. The sharp bouncebacks in growth expected after the outbreak of the Omicron variant are now likely to be more muted.
Russia’s invasion of Ukraine has added to the existing range of uncertainties and challenges central banks were confronting as the world emerged from,or at least began to cope with,the pandemic and the era of minimal inflation ended.
The odds on the Fed and its peers engineering “soft landings” for their economies have been lengthened by their tardy responses to the rekindling of inflation and by the shift in central bankers’ thinking (formalised in a new policy framework in the Fed’s case) from their previous stance of acting pre-emptively to head off inflationary pressures to reacting once inflation has been well established.
The change in the Fed’s policy in the second half of 2020 couldn’t have been more ill-timed and the damage done to its credibility by fighting the last war,where the absence of inflation was the target,rather than the one in front of it couldn’t have occurred at a worse moment.
The Fed now has to play catch up. The market expects and is pricing in at least six 25 basis points before the end of this year. Market interest rates have already moved – two-year Treasury note yields have reached their highest levels in two-and-a-half years. Yields on ten-year Treasury bonds have jumped 27 basis points in the past 10 days.
The Fed is going to have to choose between allowing inflation to rage out of control or risking a recession. It will also be mindful that adopting an inflation-first approach won’t only damage the economy but risks turmoil in financial markets.
The US sharemarket is already down 12 per cent since the start of the year,including a four per cent fall this month.
The safety net under the market – the Fed “put” that markets have taken for granted for more than 30 years – will be torn away unless the Fed gets inflation quickly under control or it believes a meltdown in the sharemarket might do real damage to the real economy or threaten the stability of the financial system.
Russia’s invasion of Ukraine has added to the existing range of uncertainties and challenges central banks were confronting as the world emerged from,or at least began to cope with,the pandemic and the era of minimal inflation ended.
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There are no painless or easy policy options for the Fed to exercise to respond to challenges it is confronting. Monetary policy is too blunt a weapon to be aimed at more than one target at a time. This week’s meetings will provide a better sense of the target it has chosen.
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