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In recent weeks the US administration as a whole – President Biden, Treasury Secretary Yellen and the Fed Chair – have appeared increasingly willing to assume the risk of a recession deliberately caused by rate hikes. Apart from during times of war, market economies generally aim to promote short-term GDP growth at the expense of other assets such as the environment, but we are currently experiencing a rare period where this priority has been deliberately usurped by a long-term target, namely price stability. Hence, Jerome Powell just explicitly acknowledged in a hearing before US senators on 22 June that recession is “certainly a possibility”, but said that this would not derail his fight against inflation. Senator Elizabeth Warren, who called Jerome Powell a “dangerous man” at an earlier hearing, reminded him of his responsibilities, referring to “millions of people out of work” in the event of recession. But the Fed Chair remained steadfast, despite acknowledging that the Fed has no sway over the prices of some of the most essential household goods such as energy and foodstuffs. The Fed thus accepts that there is a risk of recession, whilst denying that it is trying to provoke one and acknowledging that it has little influence on the most visible component of inflation. There are two risks here: the risk of a recession caused by restrictive financial conditions, and, in the worst case, the risk of a recession that will have no direct impact on the price of essential goods.
The market is under no illusions, however. US 10-year yields peaked at almost 3.50% just prior to Powell’s hearing, before rapidly falling to around 3.00% at the end of the week, reflecting fears of economic slowdown. Bond markets are even expecting a reversal of monetary policy and cuts in interest rates by the first half of 2023.
Is sacrificing short-term growth in order to beat inflation an efficient strategy? In the Fed’s view, the answer is unequivocal: price stability is the cornerstone of the economy and therefore of optimal labour market conditions. Furthermore, Powell, who generally aligns his reasoning with social considerations, added that inflation has a more marked impact on less well-off households. It is therefore a matter of urgency to bring it under control, irrespective of its cause. Paradoxically, getting inflation under control at the cost of recession would be the only way for the Fed to fulfil its dual long-term mandate of achieving price stability and full employment, even if it has the opposite effect in the short term. If this assumption turns out to be correct, Powell will be hailed as a visionary, just as former Fed Chair Paul Volcker is today considered by many as the man who defeated inflation and not as the person responsible for the massive unemployment wave at the start of the eighties, although this is also true. But if he fails, Powell will be remembered both for his economic short-sightedness in initially failing to recognise the extent of inflation, and for subsequently overreacting in an attempt to correct his mistake. Time alone will tell.
Having said that, the risk being taken by the Fed must be put in perspective. It may be less acute than could be feared. If recession does materialise in the coming months, and this is not yet certain, the damage caused could be relatively limited. In the first instance, stock market assets have already fallen substantially and are factoring in moderate recession. Additionally, central banks will again have room to manoeuvre and become more accommodative. What’s more, the banking system will not be in the first line of fire and there will be no comparison with the collapse of the financial system seen in 2008 for example. Finally, household savings, at least for those households where they exist, are rather high, and could serve as a parachute. And companies are not overly indebted.
So even if the Fed is blinded by inflation and its monetary policy proves a mistake, the current foresight of markets could help offset the consequences. In contrast, if the Fed is right on its long-term view today, the current fears of markets will prove to be excessive short-termism. Either way, the foresight of one will partly compensate for the blindness of the other.
Written on 24 June 2022 – Olivier de Berranger, CIO, LFDE