As Inflation Rises Dangerously, The Fed Chooses To Continue Its Head-in-the-Sand Policy
This will be a rude awakening for the world economy.
Inflation continues to rise month after month. The Fed and the other major global central banks may claim that this increase in inflation is temporary, but we can feel a change in their discourse as their presidents speak.
A few weeks ago, the Fed and the European Central Bank were explaining that inflation was a distant danger.
Now, faced with the evidence of the figures, these two institutions are forced to adapt their rhetoric. The policy of burying one's head in the sand cannot work forever with a subject as important as inflation.
Fed talks about inflation now, but only temporarily
In his last speech, Fed Chairman Jerome Powell continued to try to be reassuring. For the Fed, the situation is under control. The increase in inflation is only transitory. However, the figures speak for themselves.
After exceeding 4% in April 2021, inflation exceeded 5% in May 2021. This is a new high since the summer of 2008, just before the subprime crisis started in America before taking over the whole world in the form of a huge financial crisis.
If we take a closer look at the inflation figures in America, we realize that apart from the record levels reached in the summer of 2008, we have not seen inflation since February 1991. Even stronger, excluding energy and food, inflation was 3.8% in May 2021, the highest since June 1992.
The situation is moving in the same direction in China, Germany, France, and the Eurozone as a whole. This significantly rising inflation is expected to remain at high levels for a long time.
Denying this reality is extremely dangerous. But that is what the Fed and the European Central Bank are doing. The problem with inflation is that once it is there, it becomes very difficult and economically costly to reverse the trend.
Central banks choose to continue their ostrich-like approach
Central banks must therefore stop burying their heads in the sand and take on board these threats and reduce the ultra-accommodating nature of their monetary policies. This is essentially what Jerome Powell just implied when he announced that the Fed would soon reduce its purchases of debt securities.
As a reminder, the Fed's balance sheet is now close to $8 trillion:
Jerome Powell also announced the probable increase of the Fed's key rates for ... 2023.
You read that right. Jerome Powell is talking about 2023. The Fed is always trying to hide part of the reality in order not to panic financial markets that have been living on a drip for months and years. But doing so is already a mistake.
Indeed, like most central banks on the planet, the Fed has three main objectives:
Limit inflation.
Avoiding recessions.
Ensure financial stability.
The extraordinary measures taken in 2020 by the Fed worked, but ...
In 2020, the COVID-19 pandemic required exceptional measures from major central banks around the world. This resulted in zero or even negative inflation in some countries. Over a few months, a historical recession occurred, as well as a stock market crash of about one month in March 2020.
Faced with these disasters, central banks had to react by lowering key rates and by activating the famous money printing press. More than 25% of the US dollars in circulation have been printed out of thin air in the last 15 months.
This has had the effect of reducing interest rates on government bonds despite the explosion of public debts. The Fed and the European Central Bank have responded that a historic crisis requires a historic monetary policy.
After a chaotic start, we have to admit that this strategy has paid off. The financial markets have avoided a 1929-like crash and have even rebounded strongly. Growth has resumed vigorously across the globe and sustained deflation has been thwarted.
… they have trapped the Fed and the other central banks
The main problem is that central banks are now caught in their own trap. Having over-used the printing press, they now fear that if it is stopped, the economy will slow down sharply and financial markets will collapse.
Central banks are therefore taking a particularly high risk: they are letting inflation run away in the hope that it will miraculously fall.
Unfortunately, in economics, miracles are rare, especially when it comes to inflation. And especially when the leading indicators of inflation are still rising. Here are a few examples to help us understand the magnitude of the risks in the months to come:
Oil prices continue to rise.
The CRB Commodity Index for all commodities is steadily rising and is up 96% from its April 2020 level.
Many commodity prices are breaking records (e.g. copper).
The Harpex Shipping Indice of ocean freight costs for container ships reached a new all-time high on June 11, 2021.
I will stop here, but you have understood that these developments are not yet integrated into current inflation levels. They will mechanically lead to further inflationary pressures in the coming months.
Leading indicators suggest that this high inflation will last for a long time, which should push the Fed to take real action
Thus, to argue that inflation is only temporary and soon to be over, as the Fed and the European Central Bank are doing, is a blatant lie.
Rather than focusing on the evolution of financial markets and thereby fuelling stock market and bond bubbles that are particularly dangerous for the smooth running of the global economy, central banks should finally come to their senses and do their real job.
That job is to prevent inflation from becoming excessively high, which would jeopardize the continuation of growth for years to come.
Although they are supposed to be independent of the political powers, central bankers have ended up adopting the same policies as the rulers, i.e. favoring clientelism and short-termism to the detriment of credibility and longer-term objectives.
Final Thoughts
The dangerous game the Fed is playing will only produce losers at the end. The later the wake-up call, the more violent and painful the negative reactions of financial markets and international economies will be. The Fed is therefore taking a huge risk by favoring a short-term vision as it has done for several months now.
Inflationary risks are now very high for the months to come, and they threaten more than ever the smooth running of the world economy, which is still very fragile. The world economy does not need a new crisis that would be caused this time by the blindness of central banks to make the right decisions.