Fed & Inflation: Jerome Powell must act

Frankfurt On Saturday, the famous American investor Warren Buffett found remarkable words during the annual general meeting of his Berkshire Hathaway holding company: “In my opinion, Jay Powell is a hero. He did what he had to do.” comment on Jerome Powell, the head of the US Federal Reserve (Fed), was referring to his efforts to fight the corona pandemic, which helped the US economy recover quickly.

But is Powell a hero? Given the recently high inflation rate of 8.5%, this is hardly mentioned anymore. The Fed will step up the pace of its monetary tightening this week. It is almost certain that it will raise the key rate by half a percentage point. It is also likely to officially begin to reduce its balance sheet.

Fed expert Michael Feroli of US bank JP Morgan expects the key rate to be raised to a range of 0.75 to 1.0%, after 0.25 to 0.5% previously. It would then be the second consecutive rise in interest rates and, after a quarter-point increase, a movement of half a percentage point for the first time.

James Bullard, head of the St. Louis Regional Fed and member of the monetary policy committee, had previously advocated a larger interest rate hike of half a percentage point in March. Feroli writes that one or two committee members might even push for a 0.75 percentage point move on Wednesday. Now, Deutsche Bank expects three half-percentage-point steps in a row and a 3.6% interest rate target.

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Feroli also expects the Fed to cap asset purchases going forward, at $60 billion per month for government securities and $35 billion for securitized home loans. These figures have already been presented as a broad consensus in the minutes of the March meeting. Feroli suspects the cap will initially be in place for three months. Limiting purchases means that all maturing papers will not be replaced, so the total asset will decrease over time.

The Fed wants to get rid of securitized loans faster

At the central bank’s March meeting, there was already talk of whether securitized loans should be sold off a little faster. The Fed would then only own government securities. Feroli suspects that the official start of the balance sheet reduction will take place in June. Deutsche Bank is expecting a May start and estimates that total assets would fall by $1.6 trillion by the end of 2023. It is currently around $8.9 trillion, having actually slightly dropped recently.

Ellen Gaske, senior economist at US fund firm PGIM, has similar expectations to those of JP Morgan and Deutsche Bank. She recommends paying particular attention to two issues during the press conference on Wednesday evening, German time.

  • First: how quickly does the Fed want to reach a neutral level of interest rates, that is, one that neither stimulates nor slows down the economy? Gaske notes that the height of this neutral level, which cannot be measured directly, is quite controversial.
  • The second question: How will Fed Chairman Jerome (aka “Jay”) Powell comment on the trade-off between fighting inflation and avoiding a recession? More recently, she notes, he has downplayed economic risks and focused on fighting inflation. In fact, fears have increased significantly recently that the central bank could stifle the economic recovery from the corona pandemic.

Unlike the European Central Bank (ECB) and many other central banks, the Fed expressly has full employment as a second objective in addition to price stability. However, the labor market is still overheated; also because some Americans have not yet returned to look for work after the corona pandemic.

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The key interest rate primarily affects short-term yields. Bond purchases have kept long-term interest rates low in recent years, but this tends to reverse as total assets shrink. It is disputed to what extent capital markets have already anticipated the change in monetary policy.

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Yields on 5-, 10- and 30-year US government bonds were all between a healthy 2.9 and just under 3.0% on Monday. Higher yields automatically mean lower bond prices, and the surge in bond prices in recent months has already put significant pressure on stock prices, especially those of highly rated companies.

pressure on stock prices

Last year, the Fed initially called high inflation “temporary.” Because the values ​​kept rising, she received heavy criticism and has since dispensed with this vocabulary.

At 8.5%, inflation in the United States is not only one percentage point higher than that of the euro zone. It is also spread even more widely in all possible areas of the economy. Moreover, the labor market already participates much more clearly in the inflation process than in Europe.

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Diane Swonk, chief economist at US consultancy Grant Thorntons, also sees the latest quarterly results linked to rising prices. “The need to fight inflation became even clearer with last week’s earnings reports,” she wrote. “Even the biggest tech companies are feeling the impact of rising costs and supply shortages.”

In addition, the burden of higher prices has also clouded the business of online retailers. Last week, companies such as Alphabet (Google), Microsoft, Apple and Amazon announced figures, some of which were recognized with significant price losses.

After: Fed Chair Powell prepares markets for major May rate hike

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