What does a central banker do when inflation is raging at the same time as war is shaking the global economy? We will find out Wednesday when the Federal Reserve, the world’s most powerful central bank, tells us what it makes of the prevailing chaos.
The Fed is nearly universally expected to start hiking interest rates with a gentle 0.25-percentage-point nudge to the current near-zero level of its key policy rate. It has little choice but to bump rates higher given that U.S. consumer price inflation hit 7.9 per cent in February, the hottest reading in 40 years.
But what the Fed says along with the hike will be crucial. Since the start of the pandemic two years ago, central banks have supported their locked-down economies with extraordinarily easy money. Ultralow borrowing costs have encouraged runaway inflation. It is clearly time to restore monetary sanity by raising interest rates, but just how tough is the Fed prepared to get in a time of war?
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For anyone who owns stocks, the answer is crucial. Rock-bottom rates have provided a huge boost to share prices over the past two years. Take away that support too quickly and the market reaction could be ugly. On the other hand, moving too slowly runs the risk of allowing inflation to embed itself in people’s expectations, which would require even more drastic action to root out.
Inflation was already ripping before Russia invaded Ukraine, but the market generally felt the Fed had the matter in hand. Investors’ attitudes were reflected in breakeven rates, which measure how much inflation the market is expecting by comparing the yields on conventional bonds with those on their inflation-protected counterparts.
Before the invasion, breakeven rates were registering concern but not alarm. Expectations for inflation over the next five years hovered above the Fed’s 2-per-cent target, but were nearly always below 3 per cent.
After the invasion, the calm vanished. Russia and Ukraine are major commodity producers, and prices on a host of raw materials – from oil, to wheat, to palladium – jumped higher as it became clear the war and sanctions would block off much of what the two countries used to supply. Over the past couple of weeks, the market’s forecast for average inflation over the next five years has shot up to well above 3 per cent.
The current bout of inflation, which was supposed to be a transient phenomenon, now looks as if it could be both considerably larger than expected and also longer lasting.
This would seem to call for a muscular response from the Fed and other central banks. The danger is that big interest rate hikes could come at the same time as Washington is slashing its massive pandemic-era spending, turning government expenditures from a huge economic boost to a sizable drag.
As David Rosenberg of Rosenberg Research noted this week, the U.S. government has swung from a US$163-billion budget deficit in January, 2021, to a US$199-billion budget surplus this past January. This remarkably fast withdrawal of government stimulus poses a major headwind to growth.
If the Fed starts to enthusiastically hike interest rates at the same time as stimulus is disappearing, the results could be nasty. “Downside risks are more dominant now than at any time in the past two years,” Mr. Rosenberg wrote.
One way to gauge the recession danger is to look at the yield curve, which tracks the yields on government bonds of different maturities. In ordinary times, a bond maturing in 10 years pays more than a bond maturing in two years because it requires you to lock up your money for longer.
When this pattern inverts – when short-term bonds start paying more than long-term bonds – it’s a sign that something is awry. An inverted yield curve suggests the economy is going to weaken and that interest rates several years from now are going to be lower than they are now.
The most common way to measure the current economic stress level is simply to subtract the two-year U.S. Treasury yield from the 10-year U.S. Treasury yield. The smaller this gap, the more concerned investors are about the outlook. When the gap turns negative – that is, when two-year bonds pay more than 10-year bonds – the yield curve is inverted. A recession usually follows.
The 10-year-minus-two-year gap has narrowed dramatically over the past two months. It now stands at less than 0.30 percentage points. If the Fed hikes just a bit too fast, this wafer-thin margin could vanish and the curve could invert, raising alarm about a possible recession ahead.
So to sum up: The Fed’s job is to raise rates just rapidly enough to cool off inflation, while keeping the pace just slow enough to avoid any suggestion it is pushing the economy into a downturn.
This is going to be tricky. Goldman Sachs this week cut its U.S. growth forecast to a mere 1.75 per cent, and warned the probability of a recession in the next year may be as high as 35 per cent. That forecast still leaves a lot of wiggle room, but investors should be aware that the recent turbulence in stock markets could be just the start of much more upheaval to come.
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Ian McGugan