The pandemic has disrupted global supply chains, and some of those changes appear structural and permanent, as governments and businesses have responded to vulnerabilities exposed by COVID-19.
Before the pandemic, the rise of China and its dominance of consumer goods in particular, based on low labor costs and an increasingly globalized business environment, had been a major factor in several decades of unusually low inflation.
China’s unique and ineffective response to COVID outbreaks and the beginning of a decoupling of the US and Chinese economies, as geopolitical tensions mount, have added to supply chain issues and structural changes occurring in world trade.
Then, of course, there has been the Russian invasion of Ukraine and its dramatic impacts on world food and energy markets, some of which are likely to be permanent. Europe will not allow itself to become dependent on Russian energy again.
US rates will have to rise further and remain elevated longer.
Even when Powell delivered the speech last year, it was obvious that the Fed was being too accommodating and was misunderstanding the nature of the inflationary spiral. Subsequent events have compounded the damage of that error in judgment, and the Fed’s belated acknowledgment of its errors has come too late to prevent the US inflation rate from rising above 9 percent.
That means, and Powell and his colleagues now seem to accept, that US rates will have to rise further and stay at elevated levels for longer than might be the case, even if that leads to a rise in unemployment or total collapse. blown recession.
Given the sharpness of monetary policy tools (interest rates and credit availability), the Fed will have to squash demand to bring it in line with reduced supply.
Powell on Friday referred to the US experience in the early 1980s when, after a series of lukewarm attempts by the Fed to reduce inflation that spiked after the oil shocks in the 1970s, Paul Volcker raised the Fed’s policy rate to nearly 20 percent. penny.
He engineered a recession during which U.S. unemployment peaked in the double digits before the rate of inflation and the unemployment rate began to decline and usher in decades of low inflation.
“Our goal is to avoid that outcome by acting decisively now,” Powell said at Jackson Hole.
“We are taking strong and swift action to moderate demand so that it is better aligned with supply and to keep inflation expectations anchored. We’ll keep it up until we’re sure the job is done.”
His comments caused a 3.4% drop in the S&P 500 index and a 3.94% slump in the Nasdaq big-tech index, and therefore could be interpreted as a success in forcing investors to reconsider their expectations. of a soft landing for the US economy ahead. year.
Investors, however, do not appear to have fully bought into the narrative that the Fed will keep rates higher for longer, regardless of the fallout for the economy and markets. The stock market is now 5.7 percent below its peak this month (and this year), but still 10 percent above its starting point this year.
Investors remain relatively optimistic about the prospect of avoiding recession and rate cuts in the second half of next year, which is not what the Fed wants if it is to deflate inflation expectations and convince market participants. that it will not flash if they are staggered. a tantrum against rising rates and shrinking liquidity.
The Fed, of course, will have to continue its recently adopted hard line if it and Powell are to regain the credibility they lost with their misreading of events last year.
The next meeting of the Fed’s Open Market Committee in late September could be critical. Powell had previously indicated that after hikes of 75 basis points in the last two committee meetings, the Fed could end up with supercharged hikes. Markets were pricing in a 50 basis point hike next month.
“Our decision at the September meeting will depend on the totality of the incoming data and the evolution of the outlook,” Powell said on Friday, adding that “at some point, as the monetary policy stance tightens further , it will probably be appropriate to slow down.” the rate of increase.
There are some signs that global supply chains have improved and that the US inflation rate has peaked, falling from 9.1% in June to 8.5% in July. However, that is still a long way from the Fed’s target of around two percent.
If Powell and the Fed keep their nerves in check, there will be significant pain for US businesses and households, and for economies and markets outside the US, given the role that US rates and the US dollar in the global financial system, before the Fed can be confident that US inflation is finally and firmly, albeit belatedly, under control.
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