The Fed can fight inflation, but it can come at a cost

One of the main reasons Federal Reserve officials are not afraid of inflation these days is the belief that they have tools to deploy if it becomes a problem.

However, these tools come at a cost and can be deadly for the kind of periods of economic growth the US is going through.

Hiking 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 the purchase of assets and a strong political orientation also at its disposal, but it is the most powerful.

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

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

In the first half of the 21st century, concerns are growing that the central bank may be the culprit again, especially if the Fed’s easy political approach stimulates 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 still has no plans to raise interest rates over the next three years. But it is apparently based on the belief that stronger economic growth in about 40 years will generate almost no lasting inflationary pressure. , which we suspect is a view that will ultimately prove wrong, “Andrew Hunter, a senior economist at Capital Economics, said in a note Friday.

As it pledged to keep short-term debt rates anchored close to zero and to make its monthly bond purchases a minimum of $ 120 billion a month, the Fed also raised the prospects for gross domestic product. for 2021 at 6.5%, which would be the highest annual growth rate since 1984.

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

Most economists and market experts believe the Fed’s low inflation bet is safe, for now.

A litany of factors keeps inflation under control. Among them are the inherently disinflationary pressures of a technology-led economy, a labor market that continues to produce nearly 10 million fewer employed Americans than a decade ago, and demographic trends that suggest a long-term limit to pressure on productivity and prices.

“They’re pretty powerful forces, and I’d bet they would win,” said Jim Paulsen, chief investment strategist at the Leuthold Group. “It may work, but it’s a risk, because if it doesn’t work and inflation kicks in, the biggest question is, what are you going to do to shut it down? You say you have policy. What exactly is that going to be?”

Inflationary forces are quite powerful in themselves.

An economy that the Atlanta Fed continues to grow 5.7% in the first quarter has just hit a $ 1.9 trillion stimulus shock from Congress.

Another package could arrive later this year in the form of an infrastructure bill that Goldman Sachs estimates could reach $ 4 trillion. Combine it with everything the Fed does, in addition to substantial global supply chain problems that cause some products shortages, and it becomes a recipe for inflation that, while delayed, could still push in 2022 and beyond.

The most discouraging example of what happens when the Fed has to intervene to stop inflation comes from the 1980s.

Fugitive inflation began in the United States in the mid-1970s, with a rate of increase in consumer prices that exceeded 13.5% in 1980. Fed Chairman Paul Volcker was then tasked with domesticated the beast of inflation and did so through a number of interest rates. walks that dragged the economy into a recession and made him one of America’s most unpopular public figures.

Of course, the United States came out pretty well on the other side, with a strong growth momentum that lasted from late 1982 to the decade.

But the dynamics of the current landscape, in which the economic damage of the Covid-19 pandemic has been felt most acutely by people on lower incomes and minorities, make this dance with inflation especially dangerous.

“If you have to abort this recovery prematurely because we’re going to stop, we’re going to end up hurting most people that these policies were enacted to help as much as possible,” Paulsen said. “It will be the same less qualified areas that are unauthorized and with fewer competencies that will be most affected in the next recession.”

The bond market has been intermittently warning signs of possible inflation for much of 2021. Treasury yields, especially at longer maturities, have risen to pre-pandemic levels.

In turn, this action has raised the question of whether the Fed could fall victim to its own prediction errors again. The Fed led by Jerome Powell has already had to step back twice in general proclamations about long-term political intentions.

In late 2018, Powell’s statements that the Fed would continue to raise rates and reduce its non-profit balance sheet met with the historic sale of the Christmas Eve Christmas Stock Exchange. In late 2019, Powell said the Fed had ended up lowering rates for the foreseeable future, only to have to backtrack a few months later, when the Covid crisis came.

“What if the healing of the economy is more robust than even the Fed’s revised projections?” Said Quincy Krosby, chief market strategist at Prudential Financial. “The market question is always: will it really all be temporary?”

Krosby compared the Fed Powell to Alan Greenspan’s version. Greenspan led the U.S. through the “Great Moderation” of the 1990s and became known as “The Master.” However, that reputation was tarnished the following decade, when the excesses of the subprime mortgage boom triggered the wild risk-taking on Wall Street that led to the Great Recession.

Powell is betting on his reputation in a firm position that the Fed will not raise rates until inflation rises at least above 2% and the economy achieves full and inclusive employment and does not use a timetable for when tighten.

“They called Alan Greenspan‘ The Master ’until he wasn’t,” Krosby said. Powell “tells you there’s no chronology. The market tells you you don’t believe it.”

Of course, the market has gone through what Krosby previously described as “scribbles”. Bond investors may be fickle and, if they perceive rates to rise, will sell first and ask questions later.

Michael Hartnett, Bank of America’s chief market strategist, pointed to several other bond market shakes over the decades, with only the 1987 episode of the weeks leading up to the fall of the Black Monday stock market. October 19 with “significant negative effects.”

Nor does he expect the 2021 sale to have a major impact, though he warns that things could change when the Fed finally pivots.

“The majority [selloffs] they are associated with a strong economy and the Fed’s rate hikes or were a rebound that came out of a recession, “Hartnett wrote.” These episodes underscore the current low risks, but the growing risks when the Fed finally capitulates and starts walking. “

Hartnett added that the market should trust Powell when he says the policy is on hold.

“The current economic recovery is still in its early stages and the problematic inflation is at least a year away,” he said. “The Fed isn’t even close to hiking rates.”