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The Chair of the US Federal Reserve (Fed) is now on the defensive. Having stuck to his assertion that US inflation was transitory for over a year (in spite of a plethora of indications to the contrary), he has just acknowledged that this categorisation is no longer tenable. In addition to the mea culpa implicit in this admission, this ushers in a new era for the Fed: it is now inevitable that monetary policy will be forcibly tightened, after two years of ultra-accommodative measures. This change of direction is in itself a mammoth task, given that any tightening must be carried out without damaging economic momentum. But the Fed is facing four additional challenges.
Firstly, the factors driving inflation are not all within the Fed’s sphere of influence; it can do nothing about energy prices, the cost of energy transition, supply chain issues in electronic goods, or waiting times at ports. But as these factors become entrenched, they are starting to feed through, in part, into underlying inflation data for which the Fed is responsible. This is an uncomfortable position for the Fed – it must take responsibility for something it cannot control.
Secondly, the Fed must deal with the wall of debt in the US, or indeed, across the world, given that its interest rates have an influence on the entire planet. Since the 1980s, various rounds of monetary tightening have taken place against the backdrop of a more or less constant rise in the volume of total public debt to GDP. According to the St. Louis Fed, this ratio has risen from close to 30% at the start of the 1980s, to around 60% at the beginning of the 1990s, topping 100% just after the 2008 financial crisis, to reach its current level of over 120%. When debt levels have quadrupled, they cannot be dealt with in the same way. At the beginning of the 1980s, brutal monetary tightening to stamp out inflation saw intervention rates rise to 20%, but that level would be inconceivable today given the mountain of debt that has been accumulated. The Fed does have some leeway, in particular, since it holds close to a quarter of public debt, but certainly much less than in the past.
Thirdly, the Federal Reserve currently has to deal with the challenge of COVID-19. At the time of writing in early December, the extent of this challenge is still difficult to assess. The momentum of the pandemic is currently much weaker in the US than in Europe. But it is hard to believe that the US will be spared the winter wave of the Delta variant sweeping across Europe. And the extent of any Omicron wave is currently impossible to predict. Only time will tell whether this proves to be a false alert or a real wave. The Fed’s next meeting, due on 15 December, is fast approaching, and it will have to take a gamble without being able to fully assess the consequences. A crucial decision will be taken in the dark.
Lastly, the Fed is faced with the issue of the dollar. Raising rates before other central banks, in particular before the eurozone or China, will promote dollar appreciation. We’ve already witnessed that this year. But whilst a stronger dollar helps tackle inflation on imported goods, it benefits imports, and penalises exports and the repatriation of manufacturing. It would therefore further widen the trade deficit, particularly with China, which the US is unsuccessfully trying to reduce.
So Jerome Powell’s mission in December is nigh on impossible. Boxed in on all sides and with Joe Biden (who is also in a tight spot) pushing for action, he will need to show unprecedented dexterity to extricate US policy from a perilous situation. This will not be the first time, and certainly not the last. Although Jerome Powell has not yet shone in his fight against inflation, US history is full of heroes who have risen from the ashes after failed challenges. Will he soon be joining them?
Final version of 3 December 2021, Authors: Olivier de Berranger, CIO; Alexis Bienvenu, Fund Manager.