The Fed balances on a thin rope
“Whatever it takes”
Earlier this month, Federal Reserve Governor Jerome Powell was asked in Congress what he intended to do about rapidly rising inflation. He told “do whatever it takes” to bring inflation back under control. “Regardless of the cost. Indeed, producer prices in the United States have already reached a level of 10 percent. Consumer prices have risen to 7.9 percent, the highest level in 40 years. In June 1981, the then governor of the Fed, Paul Volcker, took the historic step of raising interest rates to 20 percent. A deep recession followed, but inflation started to fall from then on and would not stop until 40 years later. Paul Volcker could no longer walk the streets without security at the time. He would go down in history as the man who brought the rampant inflation of the 1970s under control.
Less spectacular
Yesterday’s interest rate increase by the American central bank was less spectacular, a quarter percent. The market had already priced in the increase in interest rates. After an initial fall, the stock markets continued their rise in recent days. The markets seem to have every confidence that the Fed can bring inflation down again without causing a major economic recession. The 2-year US government bond yield rose to 1.95 percent, but the 10-year yield remained at 2.15 percent. The yield curve is therefore flattening further.
Towards two percent
The remaining six rate hikes announced by the Fed this year appears to be priced in by the market. The Fed expects a Federal Funds Rate of close to 2 percent by the end of this year. The 10-year rate indicates an expected slowdown in growth as a result of these rate hikes, but not yet a recession. However, the Federal Reserve also indicated that it would continue to raise interest rates next year, to a level of 2.75 percent. That is precisely the level of inflation the Fed expects to see by the end of next year. Inflation and interest rates could therefore return to more or less normal levels by the end of 2023.
A balance sheet of 9,000 billion dollars
In addition to the interest rate hikes, however, the Fed is also struggling with a somewhat bloated balance sheet of almost 9,000 billion dollars in government and mortgage bonds. They want to get rid of that. Yesterday it also announced its intention to start reducing them from the next meeting – in May. The disappearance of the biggest buyer on the bond market may well cause interest rates to rise further.
Reality is usually different
In reality, however, things do not usually turn out as expected. Last month, for instance, a violent war suddenly erupted in the east of Europe. In addition to decreasing confidence in the economy, this war also caused a sharp rise in the prices of all kinds of necessary raw materials. In addition, the authorities in China appear to be having a lot of trouble realising group immunity against the coronavirus. Once again, lockdowns in the world’s second-largest economy followed, with the necessary consequences for the supply chains of many goods in the world. Not good for inflation.
Swelling criticism
There is growing criticism of the Fed’s policy. According to many experts, the American central bank is playing with fire by reacting so slowly to the sharp rise in inflation. The Fed itself expects inflation of 4.1 percent at the end of this year. That is still considerably higher than a Federal Funds Rate of close to 2 percent. It cannot be ruled out that the Federal Reserve will ultimately have to apply the brakes much harder than currently announced. It will be a real balancing act on a tightrope for the central bankers to avoid a recession in such a situation. Will Powell go down in history as a second Paul Volcker or will he and a whole generation of central bankers go down without trace?
