In November 2022, the Fed will raise interest rates again by 75 basis points back to back, raising interest rates by 300 basis points in five consecutive interest rate meetings, while continuing to implement balance sheet reduction.
Such a radical monetary tightening has not been seen in the past 40 years, which is inseparable from the current high inflation in the United States.
In September, the CPI growth rate in the United States was still as high as 8.2%, which was at a high level since 1982. Many Fed officials said that such a high level of inflation cannot be tolerated.
At the end of June 2022, Lagarde, President of the European Central Bank, delivered a “Farewell to Low Inflation” speech at the ECB Summit, believing that “we will not return to a low inflation environment”, and then announced a 50% interest rate hike on July 21 Basis points to get rid of negative interest rates in one fell swoop.
The Federal Reserve raised its inflation forecast for 2022 again in September, but still insists that the U.S. inflation growth rate is expected to fall back to 2.8% by the end of 2023, and the long-term inflation center will remain at 2.0%.
The work of macro forecasting is very difficult, and the Fed’s forecasts are constantly being falsified. Only by understanding the reasons for this situation, the role of the Federal Reserve and the underlying logic of inflation can we predict future inflation and interest rate trends.
How to make high inflation?
First, the supply-side shock is unprecedented.
The epidemic is a preview of deglobalization.
Since the 1990s, as China and other emerging countries have accelerated their opening up and integration into globalization, huge labor force, capital investment and production capacity construction have greatly increased global production capacity.
According to data from the World Bank and the World Trade Organization, the median globalization indicator rose by nearly 20 percentage points from 1990 to 2010, which is four times the increase in the previous 20 years; the scale of global trade increased by 5.3% from 7.14 trillion US dollars in 1990 times to $44.80 trillion in 2021.
Globalization and comparative advantages have “hollowed out” the manufacturing industry in the United States.
After the epidemic, countries had to stop production on a large scale and strengthen customs quarantine at the same time. China is doing its best to ensure supply, but a series of factors such as slow resumption of work in some countries, repeated epidemics, lack of key parts, international logistics congestion, and geopolitical risks have slowed supply recovery. The United States can neither produce nor get goods.
Shapiro’s (2022) research shows that one-half of the contribution to the high PCE in the United States comes from the supply side, one-third from the demand side, and the remaining one-sixth from other factors.
Geopolitical risks have triggered an energy crisis. Directly affected by the Russia-Ukraine conflict in Europe, structural conflicts broke out intensively, and natural gas prices continued to skyrocket. Energy commodities are an international market, and it is difficult for major economies to stand alone. The current situation is quite similar to the two oil crises in the 1970s.
The demand-side stimulus is also unprecedented. In the past hundred years, developed countries have never had the experience of a sudden economic stop.
In the early stage of the epidemic, the deflationary pressure generated by the economic recession came as expected. U.S. inflation continued to decline in the first half of 2020, with the CPI dropping to as low as 0.1% year-on-year, while the unemployment rate soared, hitting a new high of 14.7% with data available.
In March 2020, the Federal Reserve opened up its firepower. During the non-meeting period, it cut interest rates twice to the zero range in an emergency. At the same time, it launched a large-scale asset purchase plan-unlimited quantitative easing. US fiscal policy is more active.
Compared with other developed countries’ subsidy guarantees, the U.S. government directly distributes money to residents, and some people get more money for not working than for working. The surge in demand for some commodities and the concentrated outbreak of imbalance between supply and demand triggered the first wave of upward inflation in the second half of 2020.
As the U.S. enters the 2021 epidemic prevention period, the concentrated release of service consumption, travel-related commodity consumption, and durable goods consumption stimulated by low interest rates will follow one after another. In addition, the new U.S. President Biden immediately cashed in 1.9 trillion U.S. dollars Promises of fiscal stimulus have led to an acceleration in inflation in 2021.
The Fed is also behind the curve.
As early as the end of 2020, many former Federal Reserve officials have begun to question the view that excessive currency issuance will not lead to major inflation. Brand, the former vice chairman of the Federal Reserve, pointed out many times that in such a situation where such a huge amount of money is chasing limited commodities, the theory of monetary inflation cannot fail, and inflation has to be guarded against. Former New York Fed Chairman Dudley also held the same view.
In 2021, there will be more and more voices questioning the slowness of the Fed’s actions. Former U.S. Treasury Secretary Summers is one of the representatives, constantly calling on the Fed to step up its actions to prevent inflation from getting out of control.
In early 2022, after the Fed made a quick U-turn to implement a rare tightening policy, former Fed Chairman Bernanke also euphemistically pointed out that in the second half of 2021 (the Fed) may have made a “mistake” and acted too late, resulting in a US recession that is almost a foregone conclusion.
It is not even ruled out that the Fed may tighten too much, puncture debt and asset bubbles, cause a global economic and financial crisis, fall into a balance sheet recession, and many countries have suffered from the “Japanese disease”.
Monetary policy can “pull the rope”, but not easy to “push the rope”. The next two years will be the U.S. presidential election cycle, and U.S. politicians will try to shift the blame to each other. In the end, there will be no feathers, which may bring long-term low inflation or even deflation back again. If this is the case, it will be a total liquidation of more than 10 years of flooding.
The goal system of “causing trouble”
The Federal Reserve’s modern monetary policy framework began with the Federal Reserve Reform Act of 1977.
After experiencing the painful stagflation of the first oil crisis, the Federal Reserve was officially given the dual statutory goals of “price stability and maximum employment”.
During the second oil crisis, Volcker, the most outstanding chairman in the history of the Federal Reserve, took office, strengthened the monetary quantity control tool and stayed away from political intervention, and finally succeeded in getting the United States out of the high inflation of the 1970s. This has earned the Fed valuable credibility.
Greenspan, who succeeded him, shifted from monetary quantity tools to currency price tools, and moved from behind the scenes to the front stage, gradually emphasizing expectations management.
During the Bernanke period, the Federal Reserve officially made the 2% inflation target system explicit, further anchoring inflation expectations. At the Jackson Hole meeting in August 2020, the current Chairman Powell introduced the controversial “Average Inflation Targeting (AIT)”. Interest rate policy must look backward (that is, pre-emptive strikes) and look forward (that is, late-strike strikes) .
As a result, in just over a year, the Federal Reserve’s monetary policy statement in December 2021 no longer mentioned AIT, and the minutes of the meeting showed that “participants agreed that the goal of inflation exceeding 2% for a period of time has been achieved.” Subsequently, the talk about AIT also faded away.
There is a “fatal” asymmetrical contradiction in AIT.
After the financial crisis in 2008, the United States, like other developed countries, fell into the “vicious circle” of low inflation, and inflation reached the Fed’s 2% inflation target in only a few quarters.
To this end, AIT allows inflation to exceed 2% in the future to make up for the previous low inflation, thereby strengthening inflation expectations.
AIT originated from the reflection on low inflation, and did not solve or clarify how monetary policy should respond when inflation continues to overshoot. AIT is designed to benefit more workers from an overheated labor market, on the premise that a tight labor market will not cause inflation to deviate significantly from the Fed’s target range.
In the first half of 2021, U.S. Treasury Secretary Yellen and Federal Reserve Chairman Powell both believed that inflation is temporary and will naturally fall back in 2022. In August 2021, Powell is still insisting on the “temporary theory of inflation.”
The actual situation is that in 2021, the year-on-year growth rate of CPI in the United States will soar from 1.4% at the beginning of the year to 7% at the end of the year, and the unemployment rate will drop by 2.5 percentage points to a historical low of 3.9%. There are already signs of “wages catching up with inflation” in the labor market, further strengthening the resilience of US inflation.
If inflation continues to overshoot, inflation expectations may become unanchored, and the policy cost of controlling inflation may be beyond imagination, which will ultimately make the Fed’s AIT more worthwhile.
Figure 1: Forecast of the Fed’s future target interest rate
The Fed’s inflation targeting system and the credibility of inflation control are important reasons for the stability of inflation in the past 40 years. The concept of “overheating inflation and monetary tightening” has been deeply rooted in the hearts of the people.
Fortunately, the U.S. inflation rate in 2022 has risen to a new high since 1982, and long-term inflation has not yet become significantly unanchored. Based on trust in the Federal Reserve’s control over inflation, U.S. consumers’ five-year inflation expectations are still fluctuating around 3%, and it was 2.7% in September, which is far lower than the inflation expectations of more than 9% in the early 1980s.
According to the traditional Taylor rule, during the second half of 2021 when inflation rises and unemployment falls, the Fed should start raising interest rates.
On August 23, 2022, Stanford University professor Taylor (the author of the “Taylor Rule”) once again emphasized in an interview with Bloomberg that the Fed needs to raise interest rates to 5% in order to control inflation. Former Treasury Secretary Larry Summers once again made shocking remarks, suggesting that the Federal Reserve should face up to the challenge of inflation and strengthen its determination to control inflation by raising the unemployment rate.
Due to the shackles of AIT and the “misjudgment” of the Federal Reserve, the Federal Reserve can only fight for its name.
At the Jackson Hole meeting in August 2022, Federal Reserve Chairman Powell made a very different voice from 2021, emphasizing that the Fed’s top priority is to reduce inflation to the 2% target, and pointed out that reducing inflation may require the economy to maintain a period of sustained below-trend growth rate period.
Step by step
The last time QE exited, the Federal Reserve called it a monetary policy normalization operation, that is, a return to conventional policy from unconventional monetary policy.
In 2018, interest rates were raised four times in a row, and the last rate hike was at the end of the year. The target federal funds rate rose to 2.25%-2.50%, returning to a neutral level. Since August 2019, interest rates have been cut three times in a row, and the interest rates have not entered the tightening range from the beginning to the end. This time out of unlimited quantitative easing, the Fed explicitly called it tightening monetary policy.
In the short term, the Fed is far from achieving its goal of defeating high inflation. Inflation data, although down, is still resilient.
In July, the U.S. unemployment rate further dropped to 3.5% from the previous month, with 528,000 new non-agricultural jobs, nearly twice the market expectation, and hourly wages grew by 5.2% year-on-year, 0.6 percentage points higher than the year-on-year growth rate of core PCE.
It is worth noting that the U.S. labor force participation rate has declined for two consecutive months, lower than 1.2 percentage points at the end of 2019, and the “pit” of early retirement or permanent exit of millions of people has not yet been filled. The supply in the labor market is in short supply, making it difficult to “force” American residents to live frugally.
Loose financial conditions are also incompatible with controlling inflation.
With the same 8.5% inflation reading, the U.S. stock market will continue to fall in March 2022, while the U.S. stock market will rebound strongly in July, and there are endless voices of interest rate cuts in 2023. At present, the Federal Reserve has raised interest rates to the so-called neutral interest rate, but the real interest rate is still negative, and the Chicago Fed National Financial Conditions Index is also in a loose state.
Without the force of deflation, the situation of shortage of supply and demand cannot be alleviated. Continuing to count on the restoration of supply is tantamount to “looking for plums to quench thirst”. Moreover, the self-fulfillment of loose expectations may reduce the effect of controlling inflation.
Another failure would seriously damage the Fed’s credibility. Therefore, don’t underestimate the Fed’s determination to control inflation. Many people believe that the Fed may need to take the initiative to create an economic and financial crisis.
The subsequent tightening of the Fed is still full of uncertainties. The Fed is in “one step, one step” mode, relying on data over judgment and focusing more on inflation outcomes. This can create three situations:
One is to raise the interest rate to above 4% at the end of the year, as the market expects, and to cut the interest rate in 2023 after the tightening effect takes effect. Powell’s attitude at this year’s Jackson Hole meeting showed that the Fed does not want to repeat the mistakes of the 1970s. During the two oil crises of the 1970s, the Federal Reserve’s hesitant monetary policy stance allowed inflation to rise again in 1977.
Figure 2: Forecast of the Fed’s future target interest rate
The second is to raise interest rates to above 4% and maintain tightening until inflation falls, which is the idea currently disclosed by Powell.
The soft landing of the economy depends on luck, but a deep recession and financial crisis need to be avoided. The Fed’s fight against market easing expectations is quite similar to the “bond market massacre” in 1994, that is, the financial market should not expect “Fed put options” amid high inflation. It may be said that the deflationary effect brought about by the decline in asset prices is what the Fed is happy to see.
The third is to continue to raise interest rates until the policy interest rate and inflation converge, even higher than the growth rate of inflation. The policy interest rate and inflation converge, even higher than the inflation growth rate.
If U.S. inflation remains resilient, this scenario cannot be ruled out. This would lead to a hard landing for the economy, with the risk of sharp falls in asset prices. The advantage is that inflation is more guaranteed to fall. The problem is that the high global debt caused by long-term low interest rates lacks room to deal with high interest rates, and a global balance sheet recession and debt restructuring will occur if there is a little carelessness.
Therefore, there is another voice that “the more interest rates are raised today, the more interest rates will be cut in the future.”
In the long run, the environment of low inflation and low interest rates in the United States may also usher in a reversal.
Global savings glut and long-term stagnation are the two most famous theories to explain the “three-low environment” of low growth, low inflation and low interest rates in the United States over the past 20 years, and they are also the best starting point for understanding long-term inflation and interest rate trends in the United States.
In the future, there will be developments and changes in globalization, aging and technological innovation, which will be the three major factors affecting inflation and interest rate trends: first, deglobalization may rise; second, aging will further intensify, and major economies including China will The average population is facing the problems of accelerated aging and shrinking labor force; thirdly, technological innovation is unknown. In the past 20 years, technological innovation has been lacklustre, and the growth rate of total factors has continued to decline (Borio, 2017).
The aforementioned is the prospect of a soft landing, and eventually global inflation and interest rate centers have risen.