The question is whether the Fed pursues seven rate rises this year or pulls back to navigate a soft landing
Source - Daily Telegraph - 18/02/22
Warnings of an economic recession in the US are growing louder. Liquidity is drying up and the cost of borrowing has suddenly broken its moorings.
“The Federal Reserve is tightening into a cyclical slowdown and the risks are rising,” said Lakshman Achuthan, head of the Economic Cycle Research Institute (ECRI) in New York.
“Either the Fed will blink and give up on rate hikes or it will forge ahead until something breaks, meaning a stock market crash, or a recession, or both,” he said.
ECRI relies on early warning signals that catch turning points long before they are evident to laymen. As they say in ice-hockey, you skate to where the puck is going, not where it is.
Monetarists are edging towards the same conclusion by a different route. For the last two years they have been the scourge of the New Keynesian establishment and the major central banks. They predicted correctly that inflation would approach double digits in the US, UK, and parts of Europe, as a mechanical consequence of extreme money creation twelve to eighteen months earlier.
“It was understandable that central banks cut rates to zero and financed budget deficits at the start of Covid. The system was under great stress. But then they got the calibration all wrong and carried out asset purchases on a phenomenal scale. The last round of QE in Britain was simply stupid,” said Professor Tim Congdon from the Institute of International Monetary Research.
But today these same monetarists are voices of caution. They warn that key measures of the money supply may soon be slowing too quickly, to the point where the greater risk lies on the other side of the equation. The Centre for Financial Stability says the broadest measure in the US - divisia M4 - has slowed from a growth rate of 28pc to 5.2pc over the last year. The previous excesses are fading away.
One should not misread the current surge in commodity prices, chiefly an energy supply shock stemming from lack of investment over the last seven years. Energy spikes are not in themselves inflationary and can even be deflationary in western economies by acting as a tax on consumers. Raw material prices are in any case a lagging indicator: they typically peak at the final stage of a boom, when the fundamentals are already deflating beneath the surface.
Manufacturing PMI indexes are rolling over worldwide. The Atlanta Fed’s instant tracker of GDP in the US is running at 1.5pc for this quarter (annualised), down from a pace of 6.9pc in late 2021, and this has little to do with Omicron.
The University of Michigan’ index of US consumer confidence has dropped to levels last seen during the eurozone debt crisis. “The Sentiment Index now signals the onset of a sustained downturn in consumer spending,” said the survey.
Companies over-ordered components during the Covid crunch in global supply chains, and many are sitting on bloated stocks. The inventory cycle may swing rapidly into reverse within a few months, the textbook cause of business downturns, or recessions if allowed to fester.
The Fed’s Damascene conversion on inflation and its fire-breathing utterances over recent weeks have caused a brutal repricing of both US and global credit markets. Bank of America has sketched in seven rate rises this year as well as breakneck asset sales in the second half. Loan rates on the standard 30-year mortgage in the US catapulted through 4pc last week.
The question is whether the Powell Fed will in fact pursue such scorched-earth policies or pull back in time and navigate a soft landing, keeping the global expansion going into the early 2020s. David Wilcox, the Fed’s chief economist until mid-2018, assures me that they are fully alert to the danger.
“The Fed is not going to let itself be bullied into a more restrictive policy than is justified and they are not going to murder the recovery. Just because the markets are pricing something in doesn’t mean it is going to happen,” said Dr Wilcox, who is now at the Peterson Institute and Bloomberg Economics.
“Monetary policy is a messy business full of drills and spills, but the Fed knows it would be a terrible mistake to crush the economy in response to a temporary jump in inflation. Basically, what we have had is a massive adverse supply shock caused by the pandemic. The impulse is not permanent and the fundamental logic is still that inflation is going to take care of itself,” he said.
“Powell and company are well aware of the lessons of the 1970s when inflationary psychology was allowed to take hold. But that took fifteen years from start to finish, and we don’t yet see that dynamic at all this time,” he said.
There could even be a gift-wrapped surprise: a rebalanced economy where the reserve army of workers floods into the labour force, services roar back to life, and the supply-chain blockages fade away. “A year from now people may be talking about the price of goods actually falling, and a whole variety of really nice things could befall the economy,” he said.
Such an outcome would be close to nirvana for investors, keeping the economic expansion on track and powering Wall Street and global bourses yet higher for a further leg of this intoxicating bull market.
I would not rule it out, though professor Congdon most certainly does. “The idea that you can have a 45pc rise in the US broad money supply over three years and then bring inflation back down to 2pc without inflicting a recession is for the birds,” he said.
Even in the happiest scenario we first have to sail between the Scylla of inflation angst and the Charybdis of a growth scare. The next few months will be a test of nerves.
The broader debate comes down to whether you believe that the Ice Age Disinflation of the last forty years is finally over. Charles Goodhart from the London School of Economics argues in the Great Democratic Reversal that a fresh long-term cycle of inflation has begun as ageing populations start to eat into their collective savings, and scarce workers bid up wages in a tighter labour market.
The authors of this week’s 24th Geneva Report - Debt: The Eye of the Storm - argue nothing has really changed. The illustrious OECD-led group says the disinflationary glut of excess global savings is not going away and the same structural forces will reassert themselves once the pandemic is over.
If the latter are right, inflation will subside gradually of its own accord without the need for central bank violence. We can only hope.
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