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 the tools to implement it if it becomes a problem.

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

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 acquisitions and solid policy guidance also at its disposal, but it is the strongest.

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

Rudi Dornbusch, a well-known MIT economist, once said that none of the expansions in the second half of the twentieth century “died in old age. Everyone was killed by the Federal Reserve.”

In the first part of the 21st century, there is growing concern that the central bank could become guilty again, especially if the Fed’s light policy approach stimulates the kind of inflation that could force it to act abruptly in the future.

“The Fed said this week that it has no plans to raise interest rates over the next three years. But it seems to be based on the belief that the strongest economic growth in nearly 40 years will generate almost no sustained inflationary pressure.” what we suspect is an opinion that will eventually turn out to be wrong, “Andrew Hunter, a senior economist at Capital Economics, said in a note on Friday.

With a commitment to keep short-term lending rates close to zero and its monthly bond purchases at a minimum of $ 120 billion a month, the Fed has raised its gross domestic product outlook for 2021 to 6.5%, which would be the highest annual growth rate since 1984.

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

Most economists and market experts believe that the Fed’s low-inflation bet is a safe bet – for now.

A multitude of factors are keeping inflation under control. These include the inherently disinflationary pressures of a technology-driven economy, a job market that continues to see nearly 10 million fewer Americans employed than a decade ago, and demographic trends that suggest a limit on long-term productivity and price pressures.

“These are pretty strong forces and I’d bet they’ll win,” said Jim Paulsen, chief investment strategist at Leuthold Group. “It may solve, but it is a risk, because if it does not work and inflation starts, the biggest question is, what will you do to close it. You say you have politics. What exactly will this be? “

Inflationary forces are quite strong in themselves.

An economy that the Atlanta Fed aims to grow by 5.7% in the first quarter has just gotten a $ 1.9 trillion stimulus shake from Congress.

Another package could come at the end of this year in the form of an infrastructure bill that Goldman Sachs estimates could reach $ 4 trillion. Combine that with everything the Fed does, plus substantial supply chain problems around the world, causing a shortage of some commodities and becoming a recipe for inflation that, although delayed, could still wrap up a handful in 2022 and not only.

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

Fugitive inflation began in the United States in the mid-1970s, with consumer prices rising by more than 13.5% in 1980. Then Fed Chairman Paul Volcker was tasked with taming the beast of inflation and did so through a series of interest rates. hikers who pulled the economy into a recession and made him one of the most unpopular public figures in America.

Of course, the United States did quite well on the other side, with strong growth that lasted from the end of 1982 until that decade.

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

“If you have to abort this recovery prematurely, because we will have a knee injury, we will end up hurting most people that these policies have been adopted to help the most,” Paulsen said. “It will be the same areas with fewer qualifications, with lower companies, that will be hardest hit in the next recession.”

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

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

At the end of 2018, Powell’s statements that the Fed will continue to raise rates and shrink its balance sheet without a purpose in sight were met with a stock market sell-off on Christmas Eve. In late 2019, Powell said the Fed had finished cutting rates for the foreseeable future, only to have to retire a few months later when it hit the Covid crisis.

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

Krosby compared Powell Fed to Alan Greenspan’s version. Greenspan led the United States through the “Great Moderation” of the 1990s and became known as the “Master.” However, this reputation was tarnished in the next decade, when the excesses of the subprime mortgage boom triggered wild risk taking on Wall Street, leading to the Great Recession.

Powell expects his reputation in a firm position that the Fed will not raise rates until inflation rises at least more than 2% and the economy will reach a full job, including and will not use a timeline for when it will tighten.

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

To be sure, the market went through what Krosby described as “noise” before. Bond investors may be volatile and if they feel rates are rising, they will sell first and ask questions later.

Michael Hartnett, chief market strategist at Bank of America, pointed to several other bond market shakes over the decades, with only the 1987 episode in the weeks leading up to the October 19 black Monday stock market crash having “major negative effects.”

He also doesn’t expect 2021 sales to have a major impact, though he warns that things could change when the Fed finally pivots.

“The most [selloffs] are associated with a strong economy and rising Fed rates or have been a comeback that came out of a recession, “Hartnett wrote.” These episodes highlight the small risks today, but the growing risks when the Fed capitulates in follow and start hiking. “

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

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