The Fed must act | NZZ

Jumped as a tiger and landed as a bedside rug? If Jerome Powell does not want to completely lose his credibility as President of the American Federal Reserve, he must from now on tighten the interest rate screw and continue to rely on the financial markets with the reduction of the balance sheet in order to counteract the completely overheated labor market and the strong rise in prices in the USA to calm down.

The high demand drives the prices

After all, there are currently more vacancies than ever before in the land of unlimited opportunities, despite the recent stagnation in growth, wages are rising significantly and inflation, at a rate of 8.5 percent, has long since got out of control. After excessive fiscal stimulus measures due to the pandemic and because of too much cheap money, the demand for goods and services is greater than the supply – and that is driving prices.

However, the Fed completely missed out on developments under Jerome Powell’s leadership. “The central banks did not expect this inflation. You and many academics have based themselves on standard economic models – and if you look at the specialist literature, there is quite a lot of uncertainty about the connection between unemployment and price levels, about the neutral interest rate – and due to pandemic-related supply bottlenecks and because of the Ukraine war, this is greater than today ever,” says Harvard professor Kenneth Rogoff, describing the dilemma.

The central bank has maneuvered itself into a dead end

In his eyes, the American central bankers have maneuvered themselves into a dead end from which they won’t be able to get out anytime soon. According to Rogoff, while investors are expecting the key interest rate to be increased by half a percentage point and rapid monetary policy tightening in the coming months following the latest mini rate hike and the announcement of drastic measures this Wednesday. “The central bank can raise the key interest rate significantly before it becomes too much – and even three percent would not be enough to dampen the general upward trend in prices. They will have to turn the interest rate screw to four or even five percent to bring the inflation rate back to two or at least three percent.”

However, he is not sure that Powell and colleagues will have the courage to back up their “strong” words with action. Because like his well-known colleague Larry Summers, he expects a recession in the coming months and that the central banks want to keep all options open. “The extremely tight situation in the labor market coincides with the highest wage increases in 40 years, and there are many indications that wages will rise even further in the coming year,” argues Summers, essentially warning of the emergence of a wage-price spiral.

In the past, soaring wages have almost always led to a recession after a year or two, Summers said, and this time it’s unlikely to be any different. If his analysis is to be believed, the US Federal Reserve will no longer be able to get general inflation under control without choking off economic growth due to the unfavorable framework conditions.

The bond market is revolting

The well-known short seller Bill Fleckenstein also doubts the Fed’s strategy. “The central bank has an enormous inflation problem that it did not anticipate and which it has long denied as ‘transitional’.” In the meantime, she has upgraded rhetorically and promised to do everything to lower the inflation rate. “In fact, it only raised the key interest rate by a measly quarter of a percentage point and only recently ended the securities purchases.”

According to his logic, in view of the turbulence on the stock exchanges and after significantly rising yields on government and corporate bonds, it is negligent to say that the markets took the Fed’s announcements seriously and anticipated them. “Such narratives are false – the bond market did not anticipate rate hikes, but rather revolted. In view of the high inflation rates, investors no longer tolerate the low key interest rate level,” he argues, claiming that “if the American central bank does not consistently counteract inflation, it will lose control over interest rate developments and yields will rise uncontrollably.”

Even Mohamed A. El-Erian questions the credibility of the Federal Reserve’s monetary policy strategy. The more they chase the markets, the greater the risk of further serious political mistakes. Sooner or later it will have to make an ultimatum whether it wants to continue confirming general market expectations or face a costly recession to dampen inflation concerns, said the former adviser to the German Allianz group.

change of strategy necessary

According to his analysis, the challenge is accentuated by the fact that the Fed recognized the inflation problems incredibly late and took countermeasures just as hesitantly. Because it now has to reduce its balance sheet and raise interest rates at the same time, it takes a great deal of skill and luck to find the right balance between the various critical factors, he fears and advocates a fundamental change in strategy. In his estimation, the framework conditions have changed so much in recent months that the American Federal Reserve has to say goodbye to its “data-driven framework for action” and switch to a proactive, forward-looking strategy.

That’s certainly easier said than done. Because “we are currently experiencing a paradigm shift in macroeconomics. The consensus forecasts, from which there is traditionally little deviation, have consistently been wrong in recent years. The forecasters underestimated the extent of the upswing after the pandemic, the inflationary consequences of the stimulus packages and the fact that these will not pass so quickly, »state the experts at Deutsche Bank soberly. So what about central banks’ claims that they want to control inflation with tools that work more like an ax than a scalpel?