Federal Reserve Chairman Jerome Powell’s remarks at the Jackson Hole meeting made headlines two weeks ago. His message was clear. The Federal Reserve must be tenacious in keeping inflation in check even as the U.S. economy and labor market weaken. Equity markets fell in the meantime, disappointing investors who had hoped the Fed would turn around from tightening monetary policy.
In his remarks, Powell acknowledged that the current high inflation is the result of strong demand and constrained supply, and that the Fed’s tools are primarily acting on aggregate demand. However, he argued, “None of this relieves the Federal Reserve of its responsibility to carry out the mandate assigned to us to achieve price stability.”
Still, many observers question whether it would be appropriate to address a global supply shock by significantly raising interest rates. In their view, the Federal Reserve may be making policy mistakes that are damaging the economy and leading to significant job losses.
But skeptics should read what another Jackson Hole participant said — Isabel Schnabel, a member of the European Central Bank (ECB) Executive Committee. She argues that central banks should tighten monetary policy at a time when the global economy is weakening. Indeed, the ECB hiked interest rates by 75 basis points this week despite concerns that the EU is headed for recession. The Fed is expected to do the same at the upcoming Federal Open Market Committee meeting.
Schnabel’s thesis is that the world economy is moving away from the world economy.
“Global Moderation” with three decades of economic prosperity and relative macro-stability. During this period, central banks played a key role in achieving their low inflation targets, boosting confidence among households and businesses.
By comparison, the past three years may have entered a period of “upheaval” as the global economy was hit hard by the COVID-19 pandemic, Russia’s invasion of Ukraine, and the impact of climate change. suggesting. Schnabel argues that these forces are likely to weaken going forward, but the decisions central banks make to deal with high inflation can mitigate and limit the ultimate impact of these shocks. .
Schnabel believes central banks will either have to act cautiously (seeing monetary policy as the wrong medicine for supply shocks) or be determined to act strongly at the risk of slower growth and higher unemployment. ing. She favors the latter approach for her three reasons.
First, uncertainty about inflation requires a strong response. Schnabel argues that when inflation stays high for a long period of time, it doesn’t matter whether the cause is demand or supply. By acting early when inflation accelerates, she argues, policymakers can reduce the risk of having to act like Volcker later.
Second, the risk of destabilizing inflation expectations could undermine the credibility of central banks. She says the surge in inflation is starting to erode trust in institutions and young people don’t remember central banks fighting inflation. She also notes the rise in inflation expectations that is happening in Europe right now.
Third, Schnabel argues that central banks are facing higher “victim rates.” That is, the potential cost of acting too late and allowing inflation expectations to take hold is that, as happened in the 1970s and, he said, the early 1980s, tougher action is ultimately required and worse. means to get results.
Ultimately, Schnabel sees the challenges facing central banks today as potentially prolonging the Great Volatility or rendering the pandemic and war with Ukraine as a temporary suspension of the Great Moderation. I think that there is a nature.
This assessment provides a rationale for the Fed and other central banks to raise interest rates, but key questions remain.
There is no easy answer to this question. Ultimately it depends on how the economy and inflation go in the future. The Federal Reserve’s current projections call for the unemployment rate to rise slightly to 4.1% by 2024 to keep inflation under control. But former Economic Advisory Chairman Jason Fuhrman said a more dire forecast released by the Brookings Institution said he would need the unemployment rate to hit 6.5% to get inflation back to his average target of 2%. It points out that it concludes that there is
This score makes it easier to assess what fixed income investors are thinking. After the Jackson Hole meeting, the bond market is pricing in Fed fund interest rates that will peak at around 4% in early 2023 and then gradually decline. This is only a small change from the previously priced levels.
However, in my view, investors have consistently underestimated inflation over the past two years, believing it to be entirely related to the COVID pandemic and ignoring the impact of stimulating monetary and fiscal policies. doing. So the risk is that the fund rate is most likely to peak above 4% and eventually he will be between 5% and 6%.
Whatever the outcome, I hope the Federal Reserve understands that withdrawing tightening measures prematurely could have worse consequences. Investors perceive the Fed to ease policy whenever the stock market drops significantly. This response has contributed to the frequent asset bubbles since the 1990s. Rather, as policymakers have declared, the Fed should focus on keeping inflation and inflation expectations in check.
Dr. Nicholas Sargen is an economic consultant with Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He is the author of three of his books, including Global Shocks: An Investment Guide for Turbulent Markets.