What had been unconventional became the norm in the major economies – the US, Europe and Japan – because economic growth was, for most of the post-crisis period, anaemic and inflation, ironically, almost non-existent. The key banks, and their peers elsewhere, doubled down when the pandemic emerged.
Thus, since 2008, investors have had a rising floor and a safety net under markets underwritten by the central bankers.
Global supply chain shortages that the Fed thought last year would be transitory are, however (thanks to widespread lockdowns in China as it pursues its “zero COVID” strategy) continuing and, with the impact on energy prices of Russia’s invasion of Ukraine, contributing to the highest inflation rates in 40 years.
If, as investors seem to have concluded last Thursday, the Fed is determined to quash inflation even at the cost of a recession, there is no relief in sight and no floor under a market that has been propped up since the financial crisis by unprecedented central bank policies.
While there is some expectation that this week’s US April CPI numbers will show a slight fall from the 8.5 per cent recorded in March, an inflation rate that remains above 8 per cent gives the Fed no room to finesse its monetary policies.
It will have to tighten financial conditions severely regardless of the consequences for the economy or investors. The last time it tried to raise rates and back out of its quantitative easing program the markets went into a tailspin and it backed off. Inflation during that episode in late 2018 was, however, only about two per cent.
This time the Fed won’t have to drive interest rates to double-digit levels to kill off inflation, or the economy.
Global debt levels have, according to the International Monetary Fund, soared from 195 per cent of global GDP in 2007, ahead of the financial crisis, to 227 per cent in 2019, before the pandemic. After central banks and governments responded to the pandemic, that ratio was about 256 per cent at the end of 2021.
Governments, businesses and households are now far more sensitive to small changes in interest rates than at any time in post-war history. The Fed will be hoping that a federal funds rate of, at most, three per cent will be sufficient to bring inflation under control, although there are those forecasting the rate will top out at five per cent next year.
Former Fed chairman, Paul Volcker — who Powell said last week he admired — raised the federal funds rate to almost 20 per cent in the early 1980s to kill of the rampant inflation of the time, forcing the unemployment rate into double-digit numbers and the US into recession.
Borrowers and investors globally will be hoping that Powell achieves his “softish” landing for the US economy – US interest rate settings, and US financial markets are the dominant influence on global financial activity – but the more risk-averse will be planning for something more brutal.
Monetary policies are crude instruments. Central banks have their policy rates, their balances sheets and their voices to try to respond to the myriad of influences, some well beyond their own jurisdictions, that determine inflation levels. Historically, they tend to overshoot their target in both directions.
In this interest rate cycle, it won’t be surprising if the Fed and its peers respond either too indecisively or too harshly to the outbreak of inflation. Having lagged the curve, the risk for the US (and our Reserve Bank) is that they are forced to take tougher stances than they might have done had they moved earlier.
It is arguable that a 40-year bull market in bonds has now ended. Nasdaq’s stocks are technically in a bear market (a fall of more than 20 per cent from a peak) and the broader sharemarket is heading in the same direction.
After nearly a decade-and-a-half during which the central banks, and the Fed in particular, underwrote a fundamentals-free rise in risk assets, the wheel is turning quite abruptly. Risk and its pricing is, or at least ought to be, an input into investment decisions once again. Bull market phenomena like the chat room-inspired plunges by retail investors we saw in GameStop and other episodes ought to be an historical curiosity.
Unless the Fed gets cold feet – which it might if financial markets really started to melt down – the monetary policy settings that have driven financial markets since 2008 will be largely unwound. Better late than never, many critical of the post-financial crisis unconventional central bank policies would say.
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