The latter is substantially riskier as it creates an economic or financial “event” with more severe outcomes.
The second option, and the one chosen, is to hike rates until the economy slips into a deeper recession. Such would potentially lead to a softer landing in the economy but theoretically anchor inflation at higher levels. The first option is for central banks to pause rates and allow inflation to run its course. Such leaves only two trajectories for monetary policy. One of the interesting comments by Jerome Powell was the “window for a soft landing in the economy was narrowing.” Such confirms what we already know that the Fed is starting to realize the risk of a “hard landing” is becoming increasingly elevated.
It is only the function of time until it is evident that something breaks in the economy and bailouts are required. In other words, for the bulls hoping for a “pivot,” Powell made it clear that a “policy pivot” is coming. “If we overtighten, we can support economic activity.” Notably, the Fed is well aware of this but no longer fears creating economic havoc. What is important to note is that since the turn of the century, the outcomes have not been positive each time the Federal Reserve has started an aggressive rate hiking campaign. Since the “Great Financial Crisis,” inflation has run consistently well below that average and even the Fed’s 2% target rate. The chart below shows the periods inflation ran above or below the average inflation rate from 1982. Such is why, over the past decade, the Fed flooded the economy with liquidity and zero interest rates to boost economic activity. Deflation is a far more insidious problem than inflation longer term. If the Fed did nothing, “high prices will cure high prices.” The real risk remains a “deflationary” spiral that depresses economic activity and prosperity. The reality is that inflation is not the problem. Today, Powell says the Fed’s concern is entrenched inflation which causes pain to the economy. Deflation is a far different story, as it becomes an entrenched psychological impact that becomes difficult to dislodge.
Such makes sense as inflation is easy to deal with by hiking rates and slowing the economy. “The question of when to moderate the pace of increases is now much less important than the question of how high to raise rates and how long to keep monetary policy restrictive.”īefore the pandemic, the Fed’s storyline was to let inflation run hot rather than allow inflation to stay too low for too long. Powell made that point very clear following the latest FOMC announcement. However, those hopes got dashed each time as Jerome Powell clarified that the “inflation fight” remained the primary focus. Since June, the market rallied on hopes of a “policy pivot” by the Federal Reserve.
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