Commentary on Political Economy

Sunday, 13 March 2022

 

No-win situation: The Fed is paying the price for dragging its feet

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The US Federal Reserve Board has been behind the curve for the past year as inflation rates exploded. There’s no reason to believe that this week’s Open Market Committee meeting will be any different.

It took until last December for the Fed to decide, even as the headline inflation rate was breaking through 7 per cent, that the expectation that the surge in inflation would be “transitory” that it held throughout last year was misguided.

Led by Jerome Powell, the Fed has been slow to act and is now playing catch-up.

Led by Jerome Powell, the Fed has been slow to act and is now playing catch-up. CREDIT:AP

It’s therefore not surprising that with inflation in February hitting 7.9 per cent – before Russia invaded Ukraine and set oil and other commodity prices soaring – the Fed is expected to settle for a 25 basis point interest rate rise after the two-day meeting of the Open Market Committee that starts on Tuesday.

Earlier this month the Fed chair, Jerome Powell, told Congress that it would be appropriate to raise the target range for the federal funds rate (currently 0 to 0.25 per cent) at this week’s meeting and said he was “inclined to propose and support” a 25 basis point increase.

He indicated the Fed might also accelerate plans to shrink its balance sheet, which has nearly doubled in size since it restarted its bond and mortgage purchases in response to the pandemic.

The Fed will end that program this month but it has still been buying bonds and mortgages even as the inflation rate posted a series of steadily increasing 40-year highs.

The Russian invasion of Ukraine has pushed the oil price up from just under $US100 a barrel (it was less than $US80 a barrel at the start of the year) to more than $US130 a barrel, although it’s now trading around $US112 a barrel. US gasoline prices have been above $US4 a gallon (about $1.44 a litre) for the first time since 2008.

The invasion has also sparked steep increases in the prices of other commodities, including agricultural commodities, along with trade and financial sanctions that will have an effect on Western (and other) economies not directly engaged in the conflict. It, and the sanctions, have also added to the severe disruptions to global supply chains that were only just starting to ease.

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.

The US sharemarket is already down 12 per cent since the start of the year, including a four per cent fall this month.

The US sharemarket is already down 12 per cent since the start of the year, including a four per cent fall this month.CREDIT:AP

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 of full-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.

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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