Commentary on Political Economy

Wednesday 1 December 2021


‘Good time to retire that word’: Fed chief’s abrupt change of heart shakes markets

Stephen Bartholomeusz
6 - 8 minutes

‘Good time to retire that word’: Fed chief’s abrupt change of heart shakes markets


US inflation, it seems, is no longer transitory and the prospect of market-shaking interest rate rises in the US and elsewhere has suddenly drawn closer.

In testimony to the US Congress on Tuesday, the Federal Reserve Board chair, Jerome Powell, said the US economy was very strong and inflationary pressures were high. The risk of higher inflation had increased.

Jerome Powell has changed his views on US inflation.

Jerome Powell has changed his views on US inflation. Credit:Bloomberg

Even as US inflation has remained at levels last seen 30 years ago throughout this year – the rate was 6.2 per cent in October and even on the Fed’s preferred core inflation measure was 5 per cent – Powell and other influential board members have insisted that it would be “transitory” and deflate as the economy and global supply chains normalised from the pandemic.

Now Powell says “it’s probably a good time to retire that word and explain more clearly what we mean”.

The Fed’s change of heart flows from supply chain disruptions and demand and supply imbalances that have proved to be far more intractable than the Fed had envisaged and which have flowed into increased energy, housing and wages costs, factors that he says would “linger well into next year”.

It was only last month that the Fed began tapering the $US120 billion ($168 billion) a month of bond and mortgage purchases that were at the core of its emergency response to the initial outbreak of the pandemic last year. It planned to scale back its asset purchases – reduce the amount of liquidity it is pumping into the US system – by $US15 billion a month until the program ended in the middle of next year.

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Now, Powell says, it might have to rethink the pace at which it unwinds a program that will have expanded the Fed’s balance sheet by about $US5 trillion by the time it ends.

Given the inflationary pressures and the rapid improvement in labour markets “it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases, perhaps a few months earlier”. He said he expected a faster taper to be discussed at the Fed’s next open market committee meeting in a fortnight’s time.

The Fed has made it clear that a pre-condition for raising interest rates is the end of its quantitative easing program. If that was previously scheduled to end in the middle of next year it would now appear it could occur in the first quarter, clearing the way for what Powell has termed “lift-off”, or the first increase in the federal funds rate since 2018.

Powell’s change in tone had an immediate impact on financial markets still trying to come to grips with the emergence of the Omicron strain of the coronavirus.

Having retired the word transitory, the world will wait anxiously for more detail of how he plans to respond to inflation that is seemingly entrenched at uncomfortably high levels.

The US sharemarket, which had rebounded on Monday from its Black Friday sell-off, fell back almost 2 per cent. It is now down almost 3 per cent within a week.

Powell’s abrupt change in language and thought raises echoes of what occurred in early 2019, when the tightening of monetary policy the Fed had embarked on in October 2018 triggered a fierce backlash in markets which led to the “Powell pivot” and a sudden change of the Fed’s plans.

The potential for a market tantrum is greater this time, given how sharemarkets have traded since March last year. The market is up almost 100 per cent from its low point in March 2020 when the severity of the threat posed by the pandemic first became evident.

Wall Street fell sharply after Powell’s testimony.

Wall Street fell sharply after Powell’s testimony.Credit:AP

Warren Buffett has a crude measure to assess whether markets are under or overvalued. With long-term corporate profitability highly correlated with long-term economic growth, he has argued that the value of the sharemarket should reflect the size and growth of the economy.

The US sharemarket is now valued at more than 205 per cent of US GDP. At its nadir in March last year it was about 120 per cent of GDP. The long-term average is less than 90 per cent. The market is trading on extremely stretched valuations and is exceptionally vulnerable to any bad news.

At the moment there are two sets of threatening developments.

Higher interest rates would affect the valuations of the most highly rated stocks because the discount rate used to calculate the net present value of their future cash flows would rise.

Markets accustomed to risk-free rates below zero in real terms are at risk when rates rise although, at least for the moment, bond markets seem to be pricing in only two 25 basis point increases next year.

The extent to which the Fed and its peers elsewhere will raise rates is likely to be constrained by the big increases in governments and households’ debt levels during the pandemic. Relatively small increases in interest rates could have significant adverse consequences within real economies, which might help limit the extent of the threat to financial markets.

The pandemic, which had been seen as receding influence before Omicron emerged, remains a threat because of the doubts over the effectiveness of existing vaccines in dealing with the new strain and the demonstration that Omicron has provided of the potential for new mutations to occur.

The impact of the pandemic on global supply chains and global economic activity is likely to be to deeper and more prolonged because of the new border closures and other measures countries are now taking and create the perverse outcome of continuing high inflation rates even as economic activity slows.

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Omricon has shaken up the 2022 outlook in an instant.

Governments and their central banks don’t have the capacity to respond to new outbreaks or slowing growth that they had at the start of the pandemic.

How Powell responds to the twin challenges of inflation and the pandemic has real consequences for the other major economies because of the Fed’s outsized role in the global economy and financial system.

Having retired the word transitory, the world will wait anxiously for more detail of how he plans to respond to inflation that is seemingly entrenched at uncomfortably high levels amid the unpredictable disruptions of the continuing pandemic.

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