The end of the easy money era is rapidly approaching

The US Federal Reserve Board will be under intense pressure to step on the gas and accelerate its withdrawal of stimulus from the world’s largest economy when it meets on Tuesday, after the worst headline inflation rate in almost 40 years was posted on Friday.

The 6.8 per cent inflation rate for November was the worst since 1982, although it didn’t quite hit even worse forecasts’ of a number with a seven in front of it. The persistent out-sized inflation recordings this year have already forced a change to the Fed’s thinking and actions are now likely to force it to do more, more quickly.

Fed chief Jerome PowellCredit:

The Fed and its chairman, Jerome Powell, abandoned the complacent attitude towards decades-high inflation in the US last month when Powell said it was probably a good time to retire the word “transitory” that the Fed had used for most of this year to pass off the spike in inflation as a temporary phenomenon.

The realisation that the sustained burst of inflation at rates not seen in a generation isn’t transitory forced the Fed to change its monetary policy, under which it had been buying Treasury bonds and mortgages at a rate of $US120 billion a month.

In November the Fed began to reduce the volume of its purchases by $US15 billion a month, which would have seen the latest pandemic-inspired episode of quantitative easing end in June next year.

It is now apparent, as Powell has suggested could be the case, that while the steep increases in prices this year may have been sparked by the continuing supply chain chaos and some pandemic-related distortions in industry and the workforce, the inflationary effects are broadening through the economy and are becoming entrenched.

With the US economy growing at a rate of more than five per cent, unemployment down to 4.2 per cent last month and labour shortages becoming increasingly evident, the Fed can’t wait for global supply chains to become untangled or oil prices to subside because to delay acting would increase risks of even more dramatic and economy-threatening actions later.

That risk is magnified by the ambitious spending plans of the Biden administration. A factor in the first outbreaks of inflation in decades throughout most of the developed world has been the coincidence – unusual after decades of strict fiscal discipline being the norm in the major developed economies – of expansive fiscal policies and ultra-loose monetary policies.

Market participants are now expecting the Fed to reduces its asset purchases more quickly, perhaps doubling the decrease to $US30 billion a month. That would see the $US5 trillion program end in March, clearing the way for the first increase in US interest rates since 2018.

Earlier this year projections from the Fed’s Open Market Committee (which determines US monetary policy) saw most of its members expecting the first interest rate rise to be in 2023. Now, the bond market is pricing in as many as three 25 basis point increases next year.

The period since the 2008 crisis has been one of central bank profligacy, with ultra-low interest rates and enormous injections of liquidity into financial systems.

The US yield curve actually suggests that the Fed has changed course too late. The yield curve is as flat as it has been for nearly two years, with the spreads between the five and 30-year Treasuries’ and two and 10-year securities having narrowed significantly towards the end of this year.

In effect, that’s signalling a belief that the Fed will be forced to move aggressively to choke off inflation and in the process will choke off growth and risk recession with a steeper rise in interest rates than it had envisaged or probably envisages today.

The bond market could be wrong. The wild cards are the supply chain issues, which might be resolved more quickly than now anticipated, and the pandemic.

Each mutation of the virus causes tremors in financial markets but the latest variant, Omicron, while apparently highly contagious, also appears less virulent than previous mutations. Markets have effectively dismissed it as a threat to the economy, with the US S&P 500 index posting yet another record on Friday.

If the bond market is broadly correct, however, and the Fed (because its realisation that inflation might not be transitory was belated) is forced to raise US rates faster and further than it would prefer, a significant rise in interest rates would pose a real threat to asset prices, particularly shares and property prices, where the values have significantly inflated through the pandemic.

There’s been a quite dramatic build up in debt over the past two years, particularly (but not exclusively) governments’ debt levels. Households and businesses have also taken advantage of the historically low-interest rates and abundant supply of cheap credit.

That means an acceleration in the pace of the tightening of monetary policy in the US will have more immediate and unpleasant effects that it might have had in the past. It also means the Fed will feel constrained to some degree by the potential consequences of going too hard, too quickly. It faces some extremely difficult and delicate decisions.

Whatever the Fed does will have global implications because of the US dollar’s dominance in finance and debt and currency markets.

The period since the 2008 financial crisis has been one of central bank profligacy, with ultra-low interest rates and enormous and continuing injections of liquidity into developed economies’ financial systems.
If the Fed is out of the US bond and mortgages markets by March next year and US rates are on a sustained upward trajectory by mid-year, it could mark the end of an era of easy money and distorted pricing for risk; an era book-ended by the financial crisis and the pandemic.

In the long run that would be no bad thing – the post-GFC unconventional central bank policies have had undesirable effects on wealth inequality and the allocation and pricing of capital – but it could have some quite traumatic short-term consequences.

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