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Back in January, we warned against thinking the Federal Reserve was so scared of stock market crashes that it would refuse to raise rates aggressively — even if it appeared inflation would linger at multi-decade highs (which, full disclosure, we thought it would not).
It is easy to see why many people thought that was nonsense. Since Black Monday back in 1987, the Fed has deployed a famed “put”, repeatedly jumping in to counter turmoil with monetary support. But that put relied on the lack of any real inflationary headwinds, which meant the US central bank could provide cheap and plentiful supplies of credit to support asset prices without enabling a cost of living crisis.
Inflation is back, and the Fed’s interests and those of the market are no longer so conveniently aligned. Rates have risen faster and higher than almost anyone was positioned for, and the put argument has proved as misguided as bets that bitcoin would prove a decent inflation hedge.
The target range has risen from between zero and 0.25 per cent at the start of the year to between 2.25 and 2.5 per cent as of yesterday and is set to climb higher in the coming months, despite signs that the US economy is weakening. The S&P 500, meanwhile, is down 15.6 per cent since New Year’s Day.
It is not just investors hooked on cheap credit who have been caught out. The Fed’s monster increases are leading other central banks to go big to keep up.
Readers may have seen the excellent piece by Valentina Romei and Tommy Stubbington, published earlier this month, on how monetary policymakers the world over are supersizing their rate rises in record numbers. The standard 25 basis point shift is as dead as the Fed put; and even 50 seems meagre when chair Jay Powell is plumping for 75 at a time.
The dollar’s status as the world’s most important currency and its strength — it is up 10 per cent against major currencies this year, in part because of the Fed’s aggression — mean what your money’s worth against the greenback matters for your inflation numbers. About 50 per cent of all goods are priced in it, and it dominates settlement in global energy and food commodity markets, where price pressures have been most acute.
Despite the scale of the moves in currency markets, official foreign exchange market intervention, signed off by heads of state, has not happened. The strong dollar has, however, triggered what analysts have called “a reverse currency war”, where no one wants to add to their inflationary woes by looking weak and paying over the odds for imports — and are prepared to raise rates aggressively as a result.
This undermines another prediction we made, this one at the beginning of June, when we claimed that central banks in the US, Europe and Asia were on diverging paths.
Differences remain. Economists are betting that the European Central Bank, which deployed its own surprise supersize rise of 50bp earlier this month, will end up leaving eurozone rates at much lower levels than its US counterpart as recession in the currency bloc bites. (Though, again, we think markets might be underestimating just how focused central bankers are on fighting inflation.)
But, increasingly, the paths are the same. Even the Swiss National Bank is targeting a higher franc, after spending the past 15 years trying to weaken its notoriously sturdy currency.
Foreign central banks might, by and large, make decisions independent of domestic political pressure. But their actions suggest the dollar’s hegemony means they have far less sovereignty than we thought — and they would freely admit.
This argument that the Fed unduly influences the price of money the world over is, of course, not new. Raghuram Rajan, former governor of the Reserve Bank of India and now a professor at the University of Chicago, has repeatedly called for the US central bank to do more to take into account the global repercussions of its actions. The biggest impact is often felt by poorer countries, where higher US rates usually translate into higher local borrowing costs and capital outflows. We are surprised such calls have not come back in fashion, with the IMF and the World Bank increasingly concerned that dozens of the world’s poorest countries are teetering on the brink of default.
“If you’re an economy in the southern hemisphere with a lot of foreign currency debt, the Fed’s tightening really spells trouble,” said Adam Posen, president of the Peterson Institute for International Economics, though earlier restraint by policymakers in countries such as Brazil and Mexico may mean they are less exposed to attacks on their currencies.
The strong dollar is far from the only thing that matters for monetary policymakers right now.
It is Russia’s invasion of Ukraine that has really driven up energy and food prices this year. The actions of President Vladimir Putin are far more important than those of Powell’s, and — say what you like about the flaws in the Fed’s forward guidance — are far harder to predict.
If the war in Ukraine drags on and Russia weaponises energy exports over the European winter, this supply-side-driven inflation will continue to surge. There is not much monetary policymakers can do to change that. Unless they take up Credit Suisse’s maverick monetary maestro Zoltan Pozsar’s suggestion to trade commodities, reverse currency wars may continue to seem like the best option to manage the impact of a real one.
The Fed’s interests and those of monetary policymakers elsewhere look better aligned than those of the US central bank and financial markets. Inflation is high almost everywhere. And at some point, maybe even in September, the scale and speed of Powell’s tightening will become less aggressive.
If we are lucky, higher global borrowing costs will limit inflation without causing too big a collapse in output and rise in unemployment.
However, such a soft landing appears increasingly unlikely. What’s more, if other central banks in weaker economies overdo rate rises in an attempt to keep up with their US counterpart, the damage could be severe. That, we believe, is a real risk.
US inflation is 9.1 per cent; cheap money could not last. Nor can international monetary conventions shift overnight, regardless of the risks they create. Until price pressures show signs of drifting back to 2 per cent or — at a push — 3 per cent, the Fed will not stop. But we suspect the pain from Powell’s aggression may not be confined to investors that placed their bets on a put that is no longer in play.
This week marked the 10th anniversary of former European Central Bank president and soon-to-be former Italian prime minister Mario Draghi’s commitment to do “whatever it takes” to stave off a collapse in the euro. There have been various commentaries marking the occasion, but we would recommend this one in particular.
We liked Martin Wolf’s analysis of two books promoting opposing schools of monetary thought so much that we stole part of its headline for our own. Here is the full review.
For anyone seeking a fuller understanding of the European gas market, it is worth taking a look at this presentation from Christian Zinglersen, director of ACER, the EU agency for the co-operation of energy regulators, and this report from Fitch Ratings.
European gas prices have soared after Gazprom said it would cut gas flows through the Nord Stream 1 pipeline to just 20 per cent of capacity. Here, in pictorial form, is a sense of how dramatic the rise has been over the past few days.
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