Can the Fed pull off an “innocent inactivity”?

FExtreme inflation The longer it is shut down, the harder it becomes — and the Federal Reserve waits a long time. For the most part, the central bank said in 2021 that it had the tools to slow down inflation, but did not need to use them. Now investors are coming to terms with the fact that the Fed needs to deploy on their scale. The three-year Treasury yield has risen more than one percentage point since March 1, the biggest drastic change since the collapse of yields in January 2008 during the global financial crisis.

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The move reflects the rise in expectations that the Fed will raise interest rates by another two percentage points this year, having already raised them by a quarter of a point on March 16th. Its effects have been felt worldwide. On March 28, the Bank of Japan promised to purchase an unlimited amount of Japanese government debt within four days to protect its limit on its ten-year government-bond yield. Ten-year German bond yields, which turned positive only in January, now stand above 0.6%, even darkening the outlook for rising electricity prices.

The most important question for U.S. bond investors is that higher interest rates coming harder and faster could lead to a false “soft landing” where the heat is removed from the economy without provoking a recession. Past experience suggests that it will be difficult; Tightening has often preceded the recession. Fed Chairman Jerome Powell pointed to successful soft landings in 1964, 1984 and 1993. But these comparisons are not responsible for the difficulty of the current situation. In all these cases, the Fed did not allow inflation to rise as much as it does today.

The central bank’s latest estimates are rosy, which its critics have called a “chaotic inflation”: despite three years of steadily declining inflation, GDP Growth is above its long-term trend and both the unemployment rate and the Fed’s policy rate are unusually low. Mr Powell may have stopped calling inflation “transient”, but these predictions can only be made when inflation goes away on its own.

It seems the central bank needs to pull inflation out of the economy. Note that there is no precedent for doing this tragically, writes Bill Doodley, former head of the New York Fed. Bloomberg March 29 column that a recession was now inevitable. The term R is in the air because the yields of some short-term bonds are higher than those of long-term bonds. Such a yield-curve “catastrophe” suggests that investors expect interest rates to eventually fall as the economy weakens.

A reversal yield curve is often seen as a sign that markets think the central bank is doing wrong. The uncomfortable truth, however, is that a recession and a mistake are not the same thing if the cause of a recession is the only way to restore price stability. Paul Volker’s Fed beat inflation in the 1980s due to the recession that pushed the unemployment rate to 10.8%. No one complains of doing it inadvertently; Rather, it has chosen to pay a higher price for disinflation. This is not a position where today’s central bankers want to be; They talk as much about their duty to support jobs and growth as they do about ensuring stable prices.

The good news for Mr. Powell is that for all the talk about the yield curve, investors are mostly on his side. Most economists maintain a neutral level of interest rates, where monetary policy is not putting pressure on both the accelerator and the brake, about 2-2.5%. Both the Fed and the bond market expect the policy rate to slightly exceed that level. The rate above a notch or two neutrals can hardly be compared to the hardening of a volcano. The market expects transparency, believing that moderate tight money will be enough to control inflation.

The recent predictive record of both the central banker and the bond market, however, was poor. Just a year ago, the Fed’s message was that it was not “talking about tightening monetary policy” and that investors expected consumer prices to rise only 2.7% over the next year. If they are caught again, the Fed may find that meeting its inflation target demands that it trigger a recession. The yield curve will then reverse more steeply.

Under those circumstances, the United States would have to pay a hefty price for glacier speed work in 2021, which was justified by the perceived dangers of sudden action. This has pushed the central bank, the world economy and asset prices to more dangerous levels.

Read more from our columnist in financial markets, Buttonwood:
Nickel-trading parallels Fasco and LIBOR scandals (March 26)
Can foreign exchange reserves be approved? (March 19)
Iran’s rich stock market reflects its resilient economy (March 12)

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This article was published in the Finance and Economics section of the print edition under the headline “Late to Disinflate”

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