The US Federal Reserve (Fed) maintains all its arsenal deployed despite the sharp increase in inflation and the tightness in the labor market (companies do not find enough workers). The Fed continues to defend that this phenomenon is transitory, so there is no need to ‘put a stop to’ an economic recovery that still has a long way to go. If this scenario is fulfilled, monetary policy would continue to support the recovery and inflation would fall by itself in 2022. Everyone is happy. However, more and more voices are asking the US central bank to act now, because if it does not maybe you will have to use the ’emergency brake’ later, which could cause an accident in the markets and the economy.
Where is the Fed now?
To date, the situation is as follows: the Fed has not yet begun its tapering (although it has announced that it will start in December) and even less interest rate hikes (expected for the end of 2022 according to the official roadmap), which were once the central bank’s main tool.
Meanwhile, inflation has climbed to 6.2% per year, the highest since 1990; the underlying is at 4.6% (1991 highs); and what is more worrying, the price rises are beginning to conquer other branches of the economy and the basket of goods and services (it is no longer just a matter of energy and second-hand cars). For this reason, within the Federal Reserve itself, voices have begun to emerge calling for stronger action now to avoid a scenario in which the Fed will have to be too aggressive in the future.
What are the experts asking for?
“The strong US labor market, strong growth prospects and high inflation rates are raising doubts at the Federal Reserve whether the current stance of monetary policy remains appropriate. Two members of the Federal Reserve Board, Christopher Waller and the still Vice President Richard Clarida, they have opened the discussion on whether to accelerate the end of bond purchases at the next meeting in December, “say Commerzbank economists.
Even economists labeled as’ doves’ (they defend an expansive and accommodative monetary policy stance) are beginning to join the camp of those who ask the Fed to start stepping on the brake on bond purchases to avoid a ‘slowdown ‘which derails the economy and markets later on. Jason Furman, professor of economics at Harvard and former president of the Council of Economic Advisers to Barack Obama, has published a document in which “I recommend that the Fed establish by default the takeoff of rates in the first half of 2022, when it is likely that the unemployment rate is even lower than the 4.6% it is today, and is probably closer to the levels of 2018 (4% unemployment). Therefore, this set of rate hikes would be two or three years behind in the last cycle. “
“If anything, there are several reasons to believe that the Fed should raise rates sooner or harder this time, not least because expected inflation is higher than in 2015 (last rate hike cycle), so larger nominal increases are needed to reach the same real rate, while the unemployment rate is improving much faster, the unfilled job offers are very high and the fiscal policy is more expansionary now than then “, Furman sentence in its publication.
The move is important, says Erik Nielsen, chief economist at Unicredit, as various proponents of expansionary monetary policies (doves) are beginning to call for a progressive turn: “Traditional pigeons like former IMF chief economist Olivier Blanchard and PIIE president Adam Posen have supported Furman’s conclusion last week, “says the Unicredit economist. To all of the above should be added the recently published column by Larry Summers , former Secretary of the Treasury, who also believes that the risk of inflation getting out of control is increasing given the growing signs of overheating in the economy (rising wages, inflation reaching more components, shortage of workers …) .
What if you have to use the emergency brake?
If measures are not taken now, inflation expectations could end up loosening and there would be the risk of generating a wage-price spiral, a kind of vicious circle that would weigh on the country’s competitiveness and destabilize the framework under which agents (companies, families and investors) make their decisions in the most efficient way possible. The costs of inflation are many and dangerous.
This would force the Fed to hit the emergency brake with sharp interest rate hikes and halt bond purchases in its tracks in an attempt to drain liquidity from the market. From Bank of America Merrill Lynch (BofAML) they explained in a report on the risks of inflation that an overheating of the economy would force central banks to intervene aggressively damaging the economy and generating a shock in the markets. Both the bond market and the shares would suffer drastic corrections (their valuations are maintained in an environment of very low interest rates), which in turn would affect household consumption (a fall in the wealth effect) that have been added in a massive way to investment in risky assets (stocks, cryptocurrencies …) in recent years.
In turn, higher rates would also curb the rise in US house prices. Analysts have repeated hundreds of times that the ‘kryptonite’ for house prices are the interest rates. When the price of money begins to rise, the demand for home purchase could suffer greatly, dragging the market and impacting household wealth. This can be exacerbated if the rate hikes are large and sudden.
Among the ten risk scenarios for 2022 prepared by the Economist Intelligence Unit (EIU), there was one in which the Fed was beginning to get nervous about inflation that did not recede as expected and that forced the implementation of several interest rate increases in mid-2022.
“With very high valuation ratios for US equities, rapid increases in interest rates are sufficient to trigger a sharp stock market tightening. Given the recent high number of retail investors, the fall in share prices significantly affects consumer spending, possibly halting the US economic recovery and moving the country closer to a new recession, “said these experts.
In the 1980s inflation was also out of control. The Fed and Paul Volcker had to apply the emergency brake and bring official rates up to five points above inflation (very positive real interest rates, the opposite of today), having a full impact on the stock markets and the economy in the short term (in the long term it was shown that this financial earthquake was positive, as it gave rise to the great stability that was experienced in subsequent decades).
Today, such a movement would have unpredictable consequences. Very high valuations on the stock market and debt levels that are only sustainable at low interest rates are some of the most important dangers. A great crash on the stock markets, public debt crisis, strong price corrections in the real estate market … a very painful readjustment.
For all the above, a greater number of economists are asking the Fed to act now. Progressively tightening monetary policy now can help control inflation by cooling demand and a stronger dollar that reduces the relative ‘price’ of imports. Softer demand could also be key to undoing bottlenecks and various knots in the supply chain that have been intensified by the insatiable voracity of American households for goods.
Stephen S. Roach, a professor at Yale University and former chairman of Morgan Stanley, made this appeal to the Fed in his last column in Project Syndicate: “With inflationary pressures that are going from transitory to generalized, interest rates should be the first line of defense, not the last … My advice to the Fed is that with inflation on the rise, stop defending a bad forecast and continue the heavy lifting of raising interest rates before it is too late”.
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