And now, the yo-yo. On Wednesday 5 May, the Federal Reserve raised its key rates by half a point, the first increase of this magnitude since 2000; Wall Street soars, with the Dow Jones index posting its strongest gain since May 2020. The next day, no news from the US central bank; the Dow Jones loses more than 1,000 points, its worst tumble since 2020. Illogical? Symptomatic, rather: the stock market no longer knows where to turn, and it is not the only one. Will the Fed succeed in bringing down inflation? If so, will it do so at the cost of a recession? Has she completely missed the mark? Will she pull off a soft landing for the economy?
Monetary policy is not an exact science, but we have rarely seen so much uncertainty hanging over the American economy. And it’s been a long, long time since the all-powerful Fed found itself in the hot seat, with two questions that keep coming back: has it failed? Will she succeed? The two questions are linked, as past credibility determines that of the months to come.
Regarding the recent past, Jamie Dimon, CEO of JPMorgan Chase, believes the Fed has been “a bit late” in raising interest rates. Others are more categorical. But whose fault is it? On the side of the accusation, we find economists like Larry Summers, former economic adviser to Barack Obama, who was one of the first to sound the alarm about the danger of inflation. “Based on our assessment, overheating measures – such as strong demand growth, shrinking inventories and rising wages – have started to play out in the economy throughout 2021. But a new operational framework adopted by the Fed in August 2020 prevented it from acting until sustained inflation became apparent,” he wrote with Alex Domash, another Harvard economist, in an op-ed published by the site “The Conversation“.
Cash tap
For having wanted too much to support the economy in the summer of 2020, against the backdrop of a pandemic, the Biden administration and the central bank would have ignored the inflationary risks of such a policy. In addition to the “cash tap” left wide open by the Fed – its holdings of mortgage securities and Treasuries have doubled since the start of 2020, reaching $2.7 trillion and nearly $5.8 trillion respectively – Congress has handed out trillions of dollars in aid to households, fueling their spending.
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But this harsh observation is far from unanimous. First, much of the inflation comes not from excess demand fueled by excess liquidity, but from shocks in the supply of goods and services: the pandemic rebound with the Omicron variant, that the Fed was not anticipating when it spoke of “transitional” inflation, then the war in Ukraine. Then, everything always seems simple in hindsight, but the Fed’s decisions on rates in 2021 were taken in the context of a fragile recovery from an economy devastated by the Covid. As reminded by New York Times in an op-ed, “the central bank was trying to balance the risks: it didn’t want to quickly withdraw support for a healing labor market in response to short-lived inflation in early 2021.”
Another factor came into play: sheer force of habit. Inflation, quite simply, had disappeared from the landscape. After four decades in which the Fed’s main borrowing rate almost never fell below 2.5%, the economy has seen more than a dozen years in which it has always remained below . In the ten years following the Great Recession of 2008, the Federal Reserve was also criticized for having set an inflation target (2%) significantly higher than it actually was – the opposite criticism of the one that we address him today!
The Fed may have been “humiliated” by the ongoing inflationary spike, as economist Mohamed El-Erian argues, but it is not discredited. One thing is certain: it fully recognizes the existence of the danger and the risk of seeing an inflationary spiral that is difficult to break. “Inflation is far too high and we understand the difficulties it is causing, we are acting quickly to bring it down,” said Jerome Powell, the central bank’s president, after the announcement of a rise of 0, 5 points in key rates. After the quarter point increase decided in March, these rates are now moving in a range between 0.75% and 1%, they should continue to be raised approximately every six weeks, until stabilizing at the end of the year. around 3.25%, according to Wall Street forecasts.
More expensive money
No one doubts that the Fed has the power to tame inflation. At what speed? It is difficult to say, as the external factors (war, pandemic) are so unpredictable. But the harbingers of a slowdown are emerging. The consumer price index jumped in March (to 8.5% on an annual basis), but the core index, which excludes the most volatile elements such as energy or food, did not rose just 0.3%, its weakest rise since September. On the household side, more expensive money is starting to calm the housing sector: in less than a year, the median amount of mortgage repayment has increased from $1,165 per month to $1,690 (+ 45% ).
Much emphasis is placed in the United States on the risk of a price-wage spiral, with each feeding the other. That’s what happened in the 1970s. Since then, the power of the unions has collapsed and American companies are increasing their wages at a rate lower than that of inflation. But more than two-thirds of business costs are labor costs, and there is a danger that an overly tight labor market will make the Fed’s job harder. Powell often cites the fact that there are currently 1.7 offers for every job seeker. “It’s a very, very tight labor market, at a level that is unhealthy,” he said recently. “If we reduce the number of job vacancies to be closer to one to one [une offre d’emploi pour une demande, NDLR]there will be less upward pressure on wages.”
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The real question is whether the Fed can achieve a “soft landing” of the economy, that is to say avoid a recession. “History suggests that when the Fed acts this late, the likelihood of a recession is uncomfortably high,” El-Erian told CNBC recently. Larry Summers and Alex Domash are no more optimistic: “Since the 1950s”, they write in The Conversation, “every time inflation exceeded 4% and unemployment fell below 5%, the US economy entered a recession within two years.” And they continue: “The history of soft landings is not encouraging. We have found that each time the Fed braked hard enough to bring inflation down significantly, the economy went into recession. .”
Others cite successful soft landings. Powell, in particular, points to the precedents of 1965 and 1984, when the Fed fought overheating without putting the economy in difficulty. Each economic cycle is different, and this one is definitely a curious animal, a mixture of full employment, citizens’ anxiety about the state of the present and future world, and rising prices. Soft landing optimists at the Fed and elsewhere argue that job openings are plentiful, household socks are full and growth is showing signs of resilience, despite a (presumably temporary) setback. 1.4% year on year in the first quarter. But no one, starting with Powell, is claiming that a soft landing will be easy to trade. The approach will not be by instruments but by sight, in thick fog…