These data reflect a full month of blistering energy and other commodity prices thanks to Putin’s invasion of Ukraine turbocharging an already febrile pricing environment that was well in evidence before hostilities broke out. Indeed, that picture was emerging as far back as early 2021 when markets were at odds with central banks as to whether the incipient inflationary pressures emerging from the dislocation caused by the pandemic, were transitory or not. And it is not as if Covid has finished with us yet; while the western democracies have largely adopted a position of learning to live with Covid as an endemic infection to be dealt with like flu rather than a pandemic in a state of oxymoronic permanent emergency, China is still in hoc to a ‘zero Covid’ policy. As variants of Omicron roil around the country, whole regions are back in lockdown, in the past couple of months bringing further disruption to supply chains in the technology and heavy industry sectors.
How ironic now to look back at the end of 2020, Biden’s election and his promises of sweeping ‘progressive’ social and economic reforms, his grand plans for substantial infrastructure and post-pandemic investment, combined with the announcement of successful vaccine trials heralding the re-opening of economies after the prolonged lockdowns, and ponder the herd mentality among investors of what became labelled the ‘reflation trade’; if markets wanted inflation, they now have it in spades, much too much of it. A shining example of being careful what you wish for.
Last week, as we highlighted, it was Fed vice-chair nominee Lael Brainard banging on about the need for the Fed to shrink its balance sheet rapidly and aggressively. This week it was the turn of James Bullard, the Louisiana Fed President (and a voting member of the Open Market Committee, the Federal Reserve committee which actually determines the policy on interest rates and balance sheet policy). He’s a devoted policy hawk, with a track record of adopting the hard line, in his speech scathing of the Fed’s indolence: it’s behind the curve, it needs to get a grip and it needs to get moving. His line of attack was specific and aggressively on point: it’s no use faffing about with interest rates settling at the ‘neutral’ rate (i.e. the rate of interest which neither guns the economic motor, nor applies the brakes, the rate at which the effect is zero); to rein in runaway inflation you need to go far beyond the neutral rate and actively slow down the pace of economic growth.
But pinpointing the neutral rate as if it were some scientific, universal constant is in reality little more than the equivalent of pinning the tail on a donkey while blindfolded; the economy is dynamic, and in the current climate dominated by exogenous shocks, unusually so. Nevertheless, if a couple of weeks ago on the publication of the minutes of the most recent Open Market Committee meeting the consensus on the committee was for another six rates rises this year and three in 2023 to take the terminal Fed Funds rate to 2.85% by the second half of next year, Bullard was suggesting going further: three percentage points beyond the March quarter point should be added in short order to take the terminal rate to 3.25%.
The Open Market Committee next meets in May. Energy prices remain high but are off their recent peak and have stabilised. The duration of oil price stability is a moot point given it is being driven by the prevailing political pressure from the US and UK, but lack of will in Europe and no will at all in India and China, to close the sanctions noose on Russian energy exports, while Saudi Arabia still refuses to play ball with Biden and Boris to help make up any shortfall in global production should the sanctions sieve stop leaking. Perhaps some of the heat will have come out of accelerating inflation rates, perhaps not but it is highly unlikely that having only just begun the rate-rising cycle that the Fed will be deflected from its path at this stage. That would simply feed the narrative that far from providing a firm hand at the tiller, in fact it is rudderless, wavering at the mercy of the prevailing wind and tide. Time will tell how the debate develops and whether it is the hawks or the doves which prevail. While not panicking, markets are still in little mood to compromise, preferring to shoot first and ask questions later: bond yields continue to rise, bond prices to fall.
However, one important factor to bear in mind amid all this speculation of how fast interest rates will rise and for how long: interest rates are a very blunt tool with which to change demand-side behaviour. Analysis of long-established empirical data indicates it usually takes up to 18 months for each interest rate change (it does not matter in which direction) to be measured in terms of economic impact. Interest rates are no silver bullet.
There is the affordability argument of meeting current contractual obligations in the context of the pressure on household incomes and falling real earnings increasing risk of delinquencies. But further, as financing packages expire, owners need to make the decision whether to settle the fixed balloon payment with the rising possibility of negative equity, or simply hand the vehicle back thereby adding to a stockpile of vehicles which is growing (exacerbating downward pressure prices). You see the problem. After mortgages, for the Fed the $1.3 trillion new-and-used vehicle financing market is right up there on the list of risk sectors which might pose a systemic threat to the economy.
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