Until recently, the US Fed ignored soaring US inflation. Due to its delayed response, the resulting risks will penalize the faltering global recovery.
IN November, inflation in the United States jumped to nearly its highest level in 40 years, at 6.8%. Just days later, the Fed signaled it would end its pandemic-era bond purchases in March; paving the way for interest rate hikes by the end of 2022.
This is one of the worst inflation calls in Fed history, which will contribute to further uncertainty in the United States. Nor will it spare the rest of the world, including the most dynamic region in the world, Asia.
For months, along with some observers, I’ve warned that what the US Federal Reserve has called “transient” inflation would turn out not to be so transient and signal stagflation.
For much of 2021, Fed Chairman Jerome Powell and his colleagues have called the rise in prices transient. The rise in prices would not leave “a permanent mark in the form of higher inflation”. But that was wishful thinking.
Since the early days of the pandemic, the Fed has made two mistakes. First, it only started cutting rates late in March 2020. It ignored warnings from the World Health Organization and the drastic economic impact of the disruptive spread of Covid-19 in America. The mistake was amplified by the Trump administration which sought to protect US stock markets, to the detriment of the American people.
The second error occurred after the middle of 2021, when inflation started to climb rapidly. Instead of a timely response, the Fed signaled: This is not real inflation. He will go away. In fact, inflation has soared (see Figure 1).
FIGURE 1. 10-YEAR PERSPECTIVE: THE EFFECT OF THE PANDEMIC
On November 30, Powell dropped the term “transitional.” But the Fed was months behind.
Fed surprise double whammy
Rampant inflation only got worse in December when inflation rose 7% from a year ago. Inflation was climbing at its fastest pace in nearly four decades. Worse still, it marked the fastest increase since June 1982, when inflation was 7.1%.
President Joe Biden’s approval rating had been falling since rising inflation. Now, widespread price increases have fueled consumer concerns about the economy. As a result, Biden’s rating was plummeting.
In the United States, the rate of inflation and the rate of funds had moved quite synchronously since the 1970s, when the Great Inflation was caused by two energy crises and price increases unmatched by productivity gains. As it turned into lingering stagflation, then-Fed chief Paul Volcker resorted to record high interest rates (over 20%) causing a major recession in America, a lost decade in Latin America and extraordinary economic difficulties elsewhere.
Until the fall of 2021, the new stagflation – the combination of low interest rates and high inflation – was unsustainable (see figure 2).
FIGURE 2 50-YEAR PERSPECTIVE: TWO UNSUSTAINABLE TRAJECTORIES
Late response will only make things worse. The market had digested the signal from the Fed that it would raise short-term rates, perhaps starting as early as March. However, the bond market was hit on January 5 with the publication of the minutes of the December 2021 Fed Committee (Federal Open Market Committee or FOMC) meeting.
The unexpected surprise was that the Fed was also considering quantitative tightening; i.e. reduce its balance sheet. In addition to raising rates, it provided for quantitative tightening (as opposed to past quantitative easing). It was the double whammy strategy that surprised the market.
The Fed having woke up too late, it will have to raise rates more quickly and tighten already uncertain monetary conditions more than it did in the mid-2010s, in the aftermath of the 2008 crisis. And this will penalize the nascent recovery in America and will further delay the global recovery.
Second, a lasting rejuvenation of the global economic outlook hinges on growth, trade and investment. The Fed’s disruptive actions will weaken the growth outlook, while the misguided U.S. trade wars will further derail that outlook.
In addition, rate hikes and protectionism will add to global uncertainty, which will penalize foreign direct investment, while stimulating “hot money” — speculative capital flows — which will add to market volatility.
Fourth, the combined effect could favor a Republican comeback in the 2022 midterm elections and a Trump comeback in 2024, which is not good news given the hoped-for global recovery.
Fifth, after the pandemic and associated depression, US sovereign debt is 131% of its gross domestic product (GDP); not far from that of Italy at the start of the European debt crisis in 2010. The difference is that Italy, unlike the United States, does not represent a fifth of the world economy, just like the old the lira is not the world’s main reserve currency. . US monetary policy has global repercussions.
Sixth, like Trump, the Biden administration has calculated that debt is acceptable since rates will remain low and interest payments manageable. They miscalculated. As a result, Washington will continue to take on more debt to (presumably) fight debt.
Finally, due to impending rate hikes and quantitative tightening, the Fed’s impact will be felt across Asia, where central banks are expected to signal more hawkish positions in the coming weeks.
While China may prove more resilient to the impact of the Fed, most of Asia will not. While analysts expect Chinese, Indonesian and South Korean bonds to outperform, Thai and Malaysian bonds are expected to fare less well. Recently, the Philippine peso dipped above 51 to the dollar for the first time since April 2020 as the country’s trade deficit is expected to widen.
The impact of the Fed will lead to further weakening in Southeast Asia in 2022.
2 black swans
There are also two black swans at play. The first can cushion the impact of the Fed around the world; the second would magnify it.
Until recently, optimists – foolishly – believed that the Delta variant would be the last gasp of the global pandemic. Omicron proved them wrong. This will contribute to unforeseen challenges in labor markets and further supply disruptions around the world – and thus to further support inflation.
Moreover, due to the mismanagement of the pandemic and the huge outbreaks of infection in the West, the effects of the pandemic may linger for months, perhaps even longer, through inadequate global cooperation, responses politicized and the inequality of vaccines.
The other black swan is the Fed itself. The current stagflation has been fueled by Fed policies and the Trump-Biden trade war.
With ultra-low rates and cycles of QE (quantitative easing), the Fed has taken a risky course. This is the message of Thomas Hoenig, a former member of the Fed’s Top Policy Committee (FOMC). This path, says Hoenig in the just-released The Lords of Easy Money, will worsen income inequality in the United States, fuel dangerous asset bubbles, and make the biggest banks richer than everyone else. And if the Fed fails to emerge from its own quagmire of money printing, it could destabilize the financial system.
Perhaps unsurprisingly, when economic policies are misguided, threats of war and rearmament campaigns — from Ukraine to the South China Sea — conveniently deflect and deflect real economic challenges.
Dr. Dan Steinbock is an internationally recognized strategist in the multipolar world and the founder of Difference Group. He has worked at the Indian, Chinese and American Institute (USA), the Shanghai Institutes of International Studies (China) and the EU Center (Singapore). Learn more at https://www.differencegroup.net/