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At the start of the year, the US central bank was behind the curve on the fight against inflation. It has since made a huge effort to regain credibility with its statements and actions, which has come at the cost of a sharp and simultaneous correction in both equities and bonds – a rare occurrence. A high price has been paid, with a fall of close to 10% in the sovereign bonds of so-called rich countries and even more in equities, even though global growth is still expected at a satisfactory level of slightly over 3% in 2022, despite downgrades in recent months. In normal times, such a fall in markets could not be justified with this level of growth. But recent times have not been normal, also, due to the Fed’s about-turn.
One step ahead of inflation…
The good news is that this painful effort to adjustment seems to have paid off. Of course, in the US as in Europe, inflation is currently peaking at unprecedented levels for the last forty years or more, seriously undermining the purchasing power of households. But expected longer term inflation rates, such as those indicated in the price of inflation-linked bonds in the US, are showing clear signs of a decline. For example, on a ten-year horizon, this level has declined from over 3% during April to 2.6% currently. On a one-year horizon, it’s even more clear-cut, falling from 6.3% at the end of March to 4.7% today. It’s still way too high and above the target, but the change in direction is favourable. Accordingly, the number of US rate hikes expected by the market by the end of 2022 has fallen, with the rate now expected at 2.6%, down from 2.9% at the beginning of March. Of course, this is a modest fall, which could still change for the worse, but it is nonetheless a fall, and the first of note since the start of the war in Ukraine at the end of February.
Through its uncompromising anti-inflationary stance in recent months, the Fed got worthy of Fed Chair Paul Volcker at the start of the 1980s who raised rates to 20% and has achieved the ideal situation where it no longer needs to act to be effective. Markets believe that it has got ahead of inflation. In other words, its policy has become sufficiently restrictive so that it no longer needs to raise rates as much as was feared a month ago.
…or on the run from losing control and growth?
Of course, inflationary risk has not completely evaporated because of this. The external inflation factors that the Fed cannot control, such as the price of energy or agricultural commodities, are still largely subject to the unpredictable developments in the war in Ukraine. And inflation linked to the impact of COVID-19 on global production chains, particularly in China, may also persist or intensify, although the situation looks to be easing recently on this front. But all these factors are totally beyond the control of the Fed. Were they to rise dramatically, the Fed should be able to see this for what it is, and the market could remain relatively tolerant. In order to regain the upper hand on inflation, the Fed has put the part of its mandate concerned with growth at risk as significantly tightening monetary policy inevitably results in economic slowdown. The market has taken on this risk and has, for several weeks now, been building in the potential for recession in 2023. But the likelihood of this is still moderate.
Balancing act to gain sufficient room for maneuver
And first and foremost, by 2023, the Fed could have regained sufficient room for maneuver to again ease monetary policy and support the economy instead of cooling it down. This would mean that it really had pulled off the masterstroke – one that even Paul Volker didn’t manage in his time – of throttling inflation without plunging the economy into recession. Of course, it is too early to be certain of this. The margin between too much and too little monetary tightening is slim. But what we can say, is that the US economy looks to be in a much better position today to achieve this delicate balancing act, having focused for a certain time on one of the potential sources of a crash – inflation. A spectacular turnaround by “maverick” Jerome Powell.
Written on May 30th, 2022 by Olivier de Berranger, CIO, LFDE