The Fed can fight inflation, but it can come at the expense of future growth
Gasoline prices will be displayed at a Speedway gas station in Martinez, California on March 3, 2021.
Justin Sullivan | Getty Images
One of the main reasons US Federal Reserve officials aren’t afraid of inflation these days is because they believe they can use tools should it become a problem.
However, these tools come at a cost and can be deadly to periods of economic growth in the US.
Interest rate hikes are the most common way the Fed controls inflation. It’s not the only weapon in the central bank’s arsenal, with asset purchases adjustments and strong policy guidance, but it’s the most potent.
It’s also a very effective way of stopping a growing economy.
The late Rudi Dornbusch, a noted MIT economist, once said that none of the expansions “died in bed of old age. Everyone was murdered by the Federal Reserve” in the second half of the 20th century.
In the first half of the 21st century, there is growing concern that the central bank could become the culprit again, especially if the Fed’s simple policy approach spurs the kind of inflation that could force it to step on the brakes abruptly in the future.
“The Fed made it clear this week that it has no plans to hike rates within the next three years, but this appears to be based on the belief that the strongest economic growth in nearly 40 years will create almost no permanent inflationary pressures, which we do suspect is a view that will at some point prove wrong, “said Andrew Hunter, senior US economist at Capital Economics, in a note on Friday.
With the Fed pledging to keep short-term lending rates close to zero and adding up its monthly bond purchases at at least $ 120 billion per month, it also raised its outlook for 2021 gross domestic product to 6.5%, which would represent the highest annual growth rate since 1984.
The Fed has also raised its inflation forecast to a still mundane 2.2%, but higher than the economy has seen since the central bank began targeting a certain interest rate a decade ago.
It may work, but it is a risk because if it doesn’t work and inflation gets going, the bigger question is what are you going to do to turn it off.
Chief Investment Strategist
Most economists and market experts consider the Fed’s low-inflation bet to be safe – for now.
A litany of factors keeps inflation in check. These include the inherently disinflationary pressures of a technology-driven economy, a labor market that still employs nearly 10 million Americans less than a decade ago, and demographic trends that point to longer-term containment of productivity and price pressures.
“These are pretty powerful forces and I bet they will win,” said Jim Paulsen, chief investment strategist at Leuthold Group. “It may work, but it is a risk because if it doesn’t work and inflation gets going, the bigger question is what are you going to do to shut it down. You say you have a policy. What exactly will it be?” ? “
The forces of inflation are quite powerful in themselves.
An economy that the Atlanta Federal Reserve expects to grow 5.7% in the first quarter has just received a $ 1.9 trillion boost from Congress.
Another package could come later this year in the form of an infrastructure bill, which Goldman Sachs estimates could be $ 4 trillion. Combine that with everything the Fed does and significant problems in the global supply chain leading to shortages of some goods, and it becomes a recipe for inflation that, while delayed, will be in 2022 and above could still deal a blow.
The most daunting example of what happens when the Fed has to step in to stop inflation comes from the 1980s.
Runaway inflation began in the US in the mid-1970s when the pace of consumer price increases was 13.5% in 1980. Then Fed chairman Paul Volcker was tasked with taming the inflation beast through a series of interest rate hikes that drove the economy into recession and made him one of the most unpopular public figures in America.
Of course, the US, on the other hand, has done pretty well, with a strong growth spurt that lasted from late 1982 through the decade.
The dynamics of the current landscape, where the economic damage caused by the Covid-19 pandemic was most clearly felt by low-income earners and minorities, makes this dance with inflation a particularly dangerous dance.
“If you have to stop this recovery prematurely because we’re going to have a knee-jerk stop, we’ll end up hurting most of the people who were made these guidelines to help the most,” Paulsen said. “It will be the same disenfranchised, lower-skilled areas that will be hardest hit in the next recession.”
The bond market has been warning of possible inflation for much of 2021. The yields on government bonds, especially those with longer maturities, have risen to pre-pandemic levels.
Federal Reserve Chairman Jerome Powell
Kevin Lamarque | Reuters
This move, in turn, has raised the question of whether the Fed could again fall victim to its own forecast errors. The Fed, led by Jerome Powell, has twice had to resort to extensive proclamations of long-term political intentions.
“Is it really going to be temporary?”
In late 2018, Powell’s statement that the Fed would continue to hike rates and shrink its balance sheet with no end in sight met a historic Christmas Eve stock market sell-off. In late 2019, Powell said the Fed had cut rates for the foreseeable future only to have to back down a few months later when the Covid crisis hit.
“What if the economic recovery is more robust than even the Fed’s revised forecasts?” said Quincy Krosby, chief marketing strategist at Prudential Financial. “The question for the market is always, is it really going to be temporary? ‘”
Krosby compared the Powell Fed to the Alan Greenspan version. Greenspan steered the US through the “Great Moderation” of the 1990s and became known as “The Maestro”. That reputation was tarnished, however, in the following decade when the excesses of the subprime mortgage boom sparked wild risk on Wall Street that led to the Great Recession.
Powell puts his reputation on a firm stance that the Fed will not hike rates until inflation rises at least above 2% and the economy reaches full, inclusive employment, and does not use a tightening schedule.
“They called Alan Greenspan ‘The Maestro’ until he wasn’t,” Krosby said. Powell “tells you there is no schedule. The market tells you it doesn’t believe it.”
Of course, the market has gone through what Krosby previously referred to as “gusts”. Bond investors can be moody, and when they feel rates rising, they sell first and ask questions later.
Michael Hartnett, Bank of America’s chief market strategist, pointed to several other attacks on the bond market over the decades, with only the 1987 episode in the weeks leading up to the October 19th stock market crash on “Black Monday” “having significant negative effects ” would have.
He also doesn’t expect the sale to have a big impact in 2021, but warns that things may change when the Fed finally turns.
“Most [selloffs] are associated with a strong economy and Fed rate hikes or have been a recovery from a recession, “Hartnett wrote.” These episodes highlight low risk today, but increasing risk as the Fed finally surrenders and begins to hike. “
Hartnett added that the market should trust Powell when he says politics is on hold.
“Today’s economic recovery is still in its early stages and problematic inflation is at least a year away,” he said. “The Fed is nowhere near any rate hike.”