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

One of the main reasons Federal Reserve officials today are unafraid of inflation is the belief that they have tools to use when it becomes a problem.

However, those tools come at a cost and can be deadly to the kind of economic growth spells that the US is going through.

Raising interest rates is the most common way the Fed keeps inflation under control. It’s not the only weapon in the central bank’s arsenal, with asset purchase adjustments and strong policy guidelines, but it is the most powerful.

It is also a very effective way of stopping a growing economy.

The late Rudi Dornbusch, a noted MIT economist, once said that none of the expansions in the second half of the 20th century “died in bed of old age. Everyone was murdered by the Federal Reserve.”

In the early part of the 21st century, concerns are growing that the central bank could again be to blame, especially if the Fed’s easy-going policy approach encourages the kind of inflation that could force it to slam the brakes abruptly in the future.

The Fed made it clear this week that it still has no plans to hike interest rates over the next three years. But that apparently rests on the belief that the strongest economic growth in nearly 40 years will generate next to no lasting inflationary pressures, which is what the Fed said. we suspect. is a view that will eventually prove to be wrong, ”Andrew Hunter, US senior economist at Capital Economics, said in a note Friday.

As the Fed pledged to keep short-term interest rates anchored near zero and to keep monthly bond purchases as low as possible at a minimum of $ 120 billion per month, the Fed also raised its gross domestic product outlook for 2021 to 6.5%, which would be the highest annual growth rate since 1984.

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

Most economists and market experts believe that the Fed’s commitment to low inflation is safe for now.

A litany of factors keeps inflation in check. Among them are the inherent disinflationary pressures of a technology-led economy, a job market where there are still nearly 10 million fewer Americans in labor than a decade ago, and demographic trends that point to a longer-term limit on productivity and price pressures.

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

The inflationary forces are quite powerful on their own.

An economy following the Atlanta Fed to grow 5.7% in the first quarter has just received a $ 1.9 trillion boost from Congress.

Another package could come later this year in the form of an infrastructure bill that goes up to $ 4 trillion, according to Goldman Sachs. Combine that with everything the Fed is doing, plus substantial global supply chain issues causing shortages of certain goods, and it becomes a recipe for inflation that, although slowed, could still take a hit in 2022 and beyond.

The most daunting 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-1970s, with the rate of consumer price rise in 1980 reaching 13.5%. Then Fed Chairman Paul Volcker was tasked with taming the inflation beast, and did so through a series of interest rate hikes that plunged the economy into recession and made him one of the most unpopular public figures in America.

Of course, the US came out quite well on the other hand, with a vigorous growth spurt that lasted from late 1982 to the decade.

But the dynamics of the current landscape, in which the economic damage from the Covid-19 pandemic was most acutely felt by lower incomes and minorities, makes this dance with inflation particularly dangerous.

“If you have to end this recovery prematurely because we’re going to have a knee stop, we’re going to end up hurting most of the people that these policies have helped the most,” said Paulsen. “It will be those same disenfranchised, less qualified areas that will be hit hardest during the next recession.”

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

That action, in turn, has raised the question of whether the Fed could again fall victim to its own prediction errors. The Jerome Powell-led Fed has already twice had to reconsider sweeping proclamations about long-term policy intentions.

In late 2018, Powell’s statements that the Fed would continue to hike rates and narrow the balance sheet with no end in sight became a Christmas Eve sell-off in the stock market. In late 2019, Powell said the Fed was done cutting interest rates for the foreseeable future, but had to roll back a few months later when the Covid crisis hit.

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

Krosby compared the Powell Fed to the Alan Greenspan version. Greenspan sent the US through the “Great Moderation” of the 1990s and became known as “The Maestro”. However, that reputation was tarnished over the next decade, when the excesses of the subprime mortgage boom on Wall Street led to wild risk taking on Wall Street, triggering the Great Recession.

Powell puts his reputation on a firm stance that the Fed will not raise rates until inflation rises at least above 2% and the economy reaches full, inclusive employment, and will not use a timeline for when it will tighten.

“They called Alan Greenspan ‘The Maestro’ until he wasn’t anymore,” said Krosby. Powell “tells you there is no timeline. The market tells you it doesn’t believe it.”

Certainly, the market has experienced what Krosby previously described as “showers”. Bond investors can be fickle, and when they notice interest rates rise, they sell first and then ask questions later.

Michael Hartnett, the chief market strategist at Bank of America, pointed to several other shocks to the bond market over the decades, with only the 1987 episode in the weeks leading up to the Oct. 19 Black Monday stock market crash had “major negative spillovers.”

He also doesn’t expect the sale to have a major impact in 2021, though he warns things could change once the Fed finally turns up.

“Most [selloffs] are associated with a strong economy and Fed rate hikes or were there a recovery from a recession, “Hartnett wrote.” These episodes underscore low risk today, but increasing risk when the Fed finally capitulates and starts walking. “

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

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