The Fed may have to force a recession to get inflation under control

There were no encouraging signs in the Labor Department report which showed the Consumer Price Index rose 7.5% more than expected in January from a year earlier, marking a new high in four decades. The gains were wide and deep, suggesting inflation is taking root and potentially putting the Federal Reserve in a no-win situation.

Immediately after the release of the CPI report, money markets priced in the possibility that the central bank might be forced to raise interest rates higher and faster than it expected, including a increase of 50 basis points at the meeting of decision makers on March 15. 16 meeting. Traders also now expect a full percentage point of increases by the end of July, according to Bloomberg News. Moreover, the spread between short-term and long-term bond yields—better known as the yield curve—continued to collapse.

Jerome Powell's Fed backed into a corner.

Jerome Powell’s Fed backed into a corner. Credit:PA

All of this means that markets are increasingly seeing that the only way for the Fed to get inflation under control is to cause the economy to slow down sharply, or even force a recession. It would be the hard landing that policy makers wanted to avoid.

As recently as Wednesday, Cleveland Federal Reserve Chair Loretta Mester, who votes on monetary policy this year, said she didn’t see a “compelling case” for a half-point increase in percentage. In a sign of what could happen if the Fed decided to do what Mester called unlikely, the S&P 500 index quickly fell 1% and bond yields soared after Federal Reserve Chairman St. -Louis, James Bullard, who is also a voter this year, told Bloomberg News on Thursday that he favors raising interest rates by a full percentage point by early July. This implies an increase of at least half a percentage point at one of the three meetings by then.

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In each of the past two cycles of monetary policy tightening, from 2004 to 2006 and from 2015 to 2018, the Fed has raised rates by only quarter points, signaling each move well in advance to avoid disrupt financial markets. The reason the Fed is so careful not to introduce additional volatility into the markets is because of something called the “wealth effect.” It’s not official Fed policy, but central bank officials over the years have explained how rising prices for stocks and other assets tend to boost consumer spending and the overall economy. . “So stocks play an extremely important role, which I think is vastly underestimated,” former Fed Chairman Alan Greenspan said at a Bloomberg event in 2012.

The Fed may have no choice but to accelerate its tightening plans, whatever the blow to its reputation, to the markets and to the economy – which could be significant.

Being forced into a “shock and awe” move would also further damage the Fed’s credibility and reinforce the perception that it is behind the curve. Even though inflation accelerated for much of last year, the Fed incorrectly argued that the gains were likely only transitory. As recently as December, the Fed was planning just three quarter-point rate hikes this year; the market now expects six.

Certainly, a lot of important economic data should be released before the Fed’s next monetary policy meeting in mid-March. In a few weeks, we will have the personal consumption expenditure report for January, which the Fed considers a more important measure of inflation than the CPI. And on March 4, we will receive the monthly employment report for February, followed by the CPI report for February, which is expected to be released on March 10.

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