The Fed can fight inflation, but it can cost

Fuel prices will be displayed on March 3, 2021 at a Speedway gas station in Martinez, California.

Justin Sullivan | Getty Images

One of the main reasons why Federal Reserve officials these days are not afraid of inflation is the belief that they have tools to use should it become a problem.

However, these instruments involve a cost, and can be deadly to the types of economic growth periods that the US is experiencing.

Rising interest rates are the most common way the Fed controls inflation. It is not the only weapon in the central bank’s arsenal, with adjustments to asset purchases and strong policy guidelines at its disposal, but it is the strongest.

It is also a very effective way to stop a growing economy in its tracks.

The late Rudi Dornbusch, a well-known MIT economist, once said that none of the expansions in the second half of the 20th century “died in bed of old age. All were killed by the Federal Reserve.”

In the first part of the 21st century, concerns are mounting that the central bank may become the culprit again, especially if the Fed’s easy policy approach spurs the kind of inflation that could force it to suddenly step on the brakes in the future.

“The Fed has made it clear this week that it does not intend to raise interest rates within the next three years. But this seems to be based on the belief that the strongest economic growth in almost 40 years will generate almost no lasting inflationary pressure, which our suspicion is a view that could ultimately be proven wrong, ‘Andrew Hunter, senior US economist at Capital Economics, said in a note on Friday.

As it has promised to keep its short-term lending anchor close to zero and to keep its monthly bond purchases to a minimum of $ 120 billion a month, the Fed has also increased its gross domestic product outlook for 2021 to 6.5%, which highest annual growth rate would be. since 1984.

The Fed has also raised its inflation projection to a still fairly everyday 2.2%, but higher than the economy has seen since the central bank began targeting a specific rate a decade ago.

It may be okay, but it’s a risk, because if it does not work and inflation does start, the bigger question is what you are going to do to close it.

Jim Paulsen

chief investment strategist

Competitive factors

The most frightening 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-70s, with the rate of consumer price increases rising to 13.5% in 1980. The then chairman of the Fed, Paul Volcker, had the task of taming the inflationary beast, and did so through a series of interest rate hikes that dragged the economy into a recession and made him one of the most unpopular public figures in America made.

Of course, the US, on the other hand, came out pretty well, with a powerful growth storm that lasted from late 1982 through the decade.

But the dynamics of the current landscape, in which the economic damage due to the Covid-19 pandemic is felt most sharply by lower earners and minorities, makes this dance with inflation a particularly dangerous one.

“If you have to stop this recovery prematurely because we’re going to stop having a knee injury, we’ll end up hurting most people that this policy was implemented to help the most,” Paulsen said. “These will be the same areas with fewer skills that are less skilled in the next recession.”

The bond market has flashed warning signs of possible inflation for most of 2021. Treasury yields, especially over the longer term, have risen to pre-pandemic levels.

Federal Reserve Jerome Powell

Kevin Lamarque | Reuters

These actions, in turn, have raised the question of whether the Fed can once again fall victim to its own prediction errors. The Fed, led by Jerome Powell, has twice had to return to far-reaching proclamations on long-term policy intentions.

“Is it really going to be temporary?”

At the end of 2018, Powell’s statements that the Fed will continue to raise rates and shrink its balance sheet, without an end in sight, are a sell-out in the evening on Christmas Eve. At the end of 2019, Powell said the Fed had cut rates for the foreseeable future, only to have to fall back a few months later when the Covid crisis struck.

“What happens if the recovery of the economy is more robust than even the revised forecasts of the Fed?” says Quincy Krosby, chief market strategist at Prudential Financial. “The question for the market is always: is it really going to be temporary?”

Krosby compares the Powell Fed to the Alan Greenspan version. Greenspan steers the U.S. through the “Great Moderation” of the 1990s and becomes known as “The Maestro.” However, the reputation became tarnished the following decade when the excess of the subprime mortgage boom caused a wild risk-taking on Wall Street leading to the Great Recession.

Powell gives his reputation a firm position that the Fed will not raise rates until inflation rises to at least 2% and the economy achieves full, inclusive employment, and will not use a timeline for when it will tighten.

“They called Alan Greenspan ‘The Maestro’ until he was not,” Krosby said. Powell “tells you there’s no timeline. The market says he does not believe it.”

To be sure, the market has gone through what Krosby described as ‘squalls’ before. Bond investors can be fickle, and if they feel prices are rising, they will sell first and ask questions later.

Michael Hartnett, the chief market strategist at Bank of America, has pointed to several other pushbuttons in the bond market over the decades, with only the 1987 episode in the weeks before the stock market crash on October 19 on the Black Market, which had a serious had a negative effect.

He also does not expect the 2021 sale to have a major impact, although he warns that things could change when the Fed finally turns around.

“The most [selloffs] is associated with a strong economy and rate hikes by the Fed or was a setback from a recession, “Hartnett wrote. These episodes highlight low risks today, but rising risks when the Fed finally capitulates and starts walking. “

Hartnett added that the market should trust Powell when he says the policy is in the wheels.

“Today’s economic recovery is still in its early stages, and troublesome inflation is at least a year away,” he said. “The Fed is not even close to raising rates.”

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