(Bloomberg Notice) – The Federal Reserve plans to tighten credit even as forecasts point to a slowdown in US economic growth and a decline in recent high inflation rates. With the slightest misstep, the central bank risks either exaggerating or a further loss of credibility.
Incoming economic data has been below estimates to a degree not seen since the early days of the pandemic, based on the Economic Surprise Index from Citigroup Inc. According to Federal Reserve Bank of New York surveys. Moreover, the Fed’s attempts to stimulate borrowing and spending have been unsuccessful. Since the fourth quarter of 2019, it has inflated the money supply measured by M2 by 34%, but that currency is fallow with speed, or turnover, falling 22% to record lows.
With the end of the extra $ 300 per week in federal unemployment benefits, real incomes – already eroded by the recent surge in inflation – will fall further after falling 1.7% from January to August on a weekly basis. The highly transmissible delta variant of Covid-19 could further reduce economic activity as many companies, including Apple Inc., Amazon.com Inc., Wells Fargo & Co., Chevron Corp., Prudential Financial Inc., and Microsoft Corp . delay the opening of their offices in their entirety to employees. Salaried jobs increased only 235,000 in August, up from 1.1 million in July and the lowest since January.
While inflation rates are falling more slowly than the Fed had hoped, they should continue to decline as frictions over reopening the economy and supply bottlenecks pass. Already, the monthly basic consumer price index has fallen from 0.9% in June to 0.3% in July and 0.1% in August.
Anticipatory expenses are unlikely be stimulated by consumer fears of inflation. As usual, one-year inflation expectations reflect the recent past, but over five years, consumers are looking for 2.9% annual inflation, according to University of Michigan surveys. This expectation is undoubtedly too high, as is normal, given the human tendency to overestimate inflation. If the prices they pay go down, consumers credit them with their smart purchases, but the price hike is forced on them by forces over which they have no control, they complain.
The break-even rate, the difference between the yields of conventional US Treasury securities and inflation-protected Treasury securities, or TIPS, shows that traders expect relatively higher rates of inflation over the years. future. Yet the implicit forecast of 2.5% over the next five years is the same as in 2007.
Thus, despite the slowdown in economic growth and falling inflation rates, the Fed has reported a decrease from its monthly purchases of $ 80 billion in treasury bills and $ 40 billion in mortgage-backed securities, likely from November. Investors fear a rise in interest rates and the liquidation of treasury bills at the end of September recalled the years 2013 “Cable of anger”. Since September 22, the yield on the benchmark 10-year Treasury bond has fallen from 1.3% to 1.5% and from 1.8% to 2.1% on the 30-year bond.
The increase in yields is greatly exaggerated. Throughout the post-World War II period, inflation accounted for 60% of Treasury bond yields, and significant inflation in the coming years is unlikely. China and other Asian economies are large producers and exporters, but parsimonious consumers. Thus, the supply of goods and services exceeds demand, a highly deflationary reality.
Other factors that depress inflation include aging populations around the world which is reducing consumer spending. Even before the recent spike, Treasury yields were higher than sovereign yields in virtually every other developed country. Treasury bills are therefore attractive to foreign investors, especially since the strengthening of the dollar further improves the returns of other currencies.
The Fed’s tightening may alleviate investors’ inflationary fears, as policymakers are aware of the change. This could cause the yield curve to flatten, as the central bank pushes up short-term rates while long-term Treasury yields fall. But this scenario faces headwinds; a 100 basis point hike in the overnight federal funds rate, the Fed’s key rate, has historically led to a 36 basis point rise in 10-year Treasury yields and a 24 basis point increase in 30-year bond yields.
The Fed risks tightening to the point of precipitating major financial problems and a recession. In addition, a sharp rise in rates may well reveal excessive debt levels leading to bankruptcy in a number of financial sectors, while areas that have seen excessive speculation, such as cryptocurrencies, PSPCs and financial institutions. Individual investors linked to Robinhood Markets Inc. are vulnerable.
At the same time, the Fed increasingly looks like an arm of the federal government, not only financing a growing budget deficit by buying treasury bills, but providing the monetary fuel for stocks and other so-called risky assets since the 2008 financial crisis. Years ago, Wall Street coined the phrase “Greenspan’s bet”, suggesting that any weakness in the stock market could be “put” or sold to the Fed in exchange for central bank support. Then came the “Put Bernanke”, followed by the “Put Yellen” and now the “Put Powell”.
The last time the Fed took a truly independent and unpopular stance was when, under Paul Volcker, it raised interest rates to recession-inducing levels in 1980. But that was in reaction to recessionary levels. dire circumstances: double-digit inflation rates and foreign central banks. ‘refusal to continue supporting the dollar. I believe the Fed will try to stop before the credit crunch that would precipitate serious financial and economic problems. But it is doubtful whether the Fed can fine-tune its policy enough to restore credibility without pushing financial markets and the economy to the limit.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Gary Shilling is President of A. Gary Shilling & Co., a New Jersey consulting firm, a registered investment advisor and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation”. Some of the portfolios he manages invest in currencies and commodities.