Fed dances in the dark

At the start of 2023, markets were positioned for a relatively soft landing for the US economy, despite disagreements between the bond market, where bond prices have fallen and yields have risen (there is an inverse relationship between prices and yields) and the stock market , which has risen by around 4 percent since the beginning of the year.

The more bearish bond market appears to be winning the argument, with Powell’s comments helping to push yields even higher.

“Will working people be better off if we just quit our jobs and inflation stays 5 [or] 6 percent?’

Fed Chairman Jerome Powell

The US two-year Treasury yield broke above 5 percent on Monday for the first time since mid-2007. The spread between 2-year and 10-year yields is now more than a percentage point, the first time since 1981.

The US yield curve is now quite steeply inverted – yields on shorter-dated securities are higher than those with longer durations, belying the notion that investors should be compensated more for the risk of holding the securities longer.

Every post-war US recession was preceded by a yield curve inversion, although not every curve inversion was followed by a recession.

The Fed is in a similar position to the Reserve Bank as it faces the tricky and insidious trade-offs involved in fighting decades of high inflation. Central bankers are acutely aware of the potential for unnecessary damage to economic growth and the high levels of unemployment and social hardship they will cause if they raise interest rates too high, or leave them high for too long.

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When US Senator Elizabeth Warren suggested that the Fed was trying to throw people out of work, causing millions of Americans to lose their jobs, Powell responded that inflation was extremely high and workers were suffering badly. The Fed took the only action it had to bring inflation down.

“Will working people be better off if we just quit our jobs and inflation stays 5 [or] 6 percent?” he asked. RBA Gov. Philip Lowe made similar comments.

Central bankers know that the price and availability of money are their only means of responding to bursts of inflation, increased unemployment and fiscal stress, which are unpleasant but necessary outcomes – even goals – if an inflationary cycle is to be broken.

Her work has been exacerbated by the post-pandemic environment of very tight labor and housing markets, disrupted (albeit sharply recovering) supply chains, and heavy consumption by households with savings bulging during the worst of the pandemic as governments opened up the fiscal system difficult cone.

The war in Ukraine, rising geopolitical tensions and the decoupling of significant sectors of the US and other economies from China have added to global economic uncertainties and risks.

The difference between the anomalous post-financial crisis period of negative real interest rates and negligible inflation that preceded the pandemic and the monetary policy attitudes and tolerable inflation rates in a “new normal” environment also complicates considerations.

In the US, an additional risk factor with global implications is the confrontation between the Biden administration and Republicans over the US government debt ceiling. At a US Senate hearing on Monday, Moody’s Analytics chief economist Mark Zandi said if the government debt were not paid, 7 million jobs could be lost, there would be a deep recession and markets would collapse.

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Moody’s also said 2.6 million jobs and a year’s worth of economic growth would be lost if Joe Biden gave in to Republican demands and cut government spending to avoid such a default. The best estimate is that the US will default in July or August without an agreement to raise the debt ceiling, which currently stands at $31.4 trillion.

All of these “known unknowns” have left the Fed and, to varying degrees, other central bankers – and financial market participants – essentially dancing in the dark and becoming increasingly data-dependent and reactive.

Each piece of economic information becomes more important than the last and has the potential to shake expectations and create wild swings in financial markets

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