This analogy illustrates the challenge currently faced by the US Federal Reserve (“Fed”). If it tightens too far too fast (e.g. tapers the $120 billion monthly bond purchases and increases interest rates), stock and bond markets will crash; if it allows the current exceedingly loose monetary policy to prevail, inflation may careen out of control.
The Fed claims it will take a “data driven” approach, taking their cues from the market. The market now expects tapering of bond purchases and an increase in interest rates. However, beyond a relatively minor increase in interest rates, markets will push back (“tantrums”). The Fed may try repeatedly to tighten.
This bouncing back and forth will create volatility, but the end result is likely to be a continuation of inflation and negative real interest rates, for the reasons set out below:
(a) Inflationary forces remain strong
The Fed belatedly “retired” use of the word ‘transitory’ as applied to inflation—the delay makes the policy response more difficult.
Most economists, and the market itself, is expecting inflation to diminish (e.g. from the 6.8% annual rate announced on December 10—the highest inflation rate since 1982!), due to the fact that there were certain base rate effects in 2020, and some strong deflationary forces at play today (e.g. ageing demographics and technological innovation). Inflation may yet prove surprisingly strong:
- The world faces a self-inflicted energy crisis. The goal of carbon neutrality has deterred energy majors from investing in future fossil energy supply, while creating an inflationary spiral in commodities required for electrification. We face record oil and gas prices, which could go higher.
- Ammonia prices have roughly quadrupled in the last 18 months. This is the most important input for agriculture. Substantial food inflation is virtually inevitable.
- The US has reached full employment (11 million jobs going begging), leading to wage inflation.
- Various bottlenecks in the global economy (from container shipping to microchips) are likely to take years to resolve. The longer inflation prevails, the more inflationary expectations become embedded. We have perhaps already passed a tipping point.
There is no politician with sufficient backbone to make painful decisions necessary to curtail inflation (a la Paul Volcker):
- With Brainard appointed as Fed Vice-Chair (confirmation pending), the Fed has tilted farther towards loose monetary policy.
- Janet Yellen seems to have a blind spot when it comes to inflation.
- A Democratically controlled Congress seems to believe in Modern Monetary Policy (a theory justifying printing almost limitless amounts of money).
Even if a Volcker did exist today, debt levels are far higher than during the Volcker era. Global debt has skyrocketed to over 365% of global GDP and is still rising. For every percent increase in bond rates, the US Government must pay an additional USD 290 billion in interest costs. In 2020—the US Federal Government collected just over $3 trillion in taxes while spending almost $6.5 trillion. If the 10 year treasury bond rate would revert to 4-5% (as Jamie Dimon, CEO of JPMorgan, predicts), not only would that trigger an extra trillion in interest expenditures in the US– defaults would be triggered on emerging market debt, junk bonds, etc. The US Government could be heading towards a Government Debt/GDP ratio of 200% within 5-10 years. There is much incentive for the Fed to back off rate increases.
(d) The Pandemic
The pandemic has served as the trigger and excuse for exceedingly loose monetary policy– untargeted helicopter money to US citizens and lending guarantees to banks. Omicron today; tomorrow the next mutation. The unprecedented uncertainty surrounding Covid mutations makes planning the re-entry angle next-to-impossible.
(d) Inflation is the lesser political evil
Joe Biden faces political heat from rising inflation; heat from a market collapse, recession or depression would be far greater. Continuation of inflation at 5-7%, with 10 year treasuries at 2-3%, would provide the enormous benefit of inflating away the national debt, a temptation difficult to resist.
(e) The Fed is losing its levers of control
Economist Russell Napier argues that Government guarantees have encouraged greatly increased bank lending, a potentially much larger source of money supply increase than the Fed printing money—(unlike money printing during the 2008 crisis, which ended up in bank reserves, not increasing lending and money supply). Napier argues the Fed is becoming irrelevant.
The coming decade is likely to be characterized by inflation and negative real interest rates. Count on volatility!
This article is for educational purposes only and must not be construed as investment advice. Investors should obtain their own financial advice.