Want to Understand the Cornelian Dilemma the Fed Is Facing? This Automotive Metaphor Will Help You.
Central bankers will have to pilot with mastery.
The Cornelian dilemma in which the world's central bankers find themselves may seem difficult to understand for the general public. It is however essential to understand because it will impact you strongly in the months and years to come. From the Fed to the European Central Bank (ECB), all of the world's largest central banks are in a dilemma today.
To understand the nature of this dilemma, I will try to relate it to you with the metaphor of a race car.
This race car is racing at full speed on a track. At the end of the straight line, there is a sharp turn. You were so focused on the speedometer that you almost forgot about that corner and kept driving at full speed.
Now that you see the sharp turn, you realize that your speed is too high to pass safely. Logically, you have no choice but to use the brakes fully.
However, like any good race car driver, you know that if you brake too hard, there's a good chance your car will skid, and you'll go off the road. So you have to find the perfect amount of braking to get through that tight corner while avoiding going off the road.
I think this metaphor will speak to everyone. Well, that's the situation in which the heads of the major US central banks, from Jerome Powell to Christine Lagarde, find themselves.
In the case of the Fed and the ECB, the tight corner to negotiate is extremely high inflation. It was still 8.3% in April 2022. A 40-year high in America. The situation is not much better in Europe: 7.5% in April 2022. The central bankers must therefore slow down their ultra-accommodating monetary policies to move towards a tightening cycle.
The problem is that they took too long to slow down. This inflection of their monetary policies should have been started several months ago. But the central banks have not done so. Probably for lack of courage.
To slow down is to increase interest rates. This is obvious. Nevertheless, there is a problem: the economy is slowing down because of inflation. Unfortunately for central bankers, the slowing economy is too slow to bring down inflation.
If central banks brake too hard, i.e. raise interest rates too quickly, then entering the sharp turn at the end of the straight line will result in a skid and a run off the road. That skid is a recession in the American and European economies.
You can now see the dilemma that central bankers are facing today.
Their strategy is to put on the brakes, but not too hard, even if it means giving the impression that they are not taking the inflationary risk seriously. Central bankers are hoping that the slowdown in the economy, which has already begun, coupled with the start of an interest rate hike, will bring inflation down.
This is almost wishful thinking at this level.
The likelihood of coming out of the sharp turn we are about to take unscathed is low. Yes, but low does not mean zero. And that's thanks to the markets. And yes, markets do anticipate things.
If investors and traders are convinced that the economy is going to slow down, they will sell oil or commodities forward. They will speculate on the downside. This behavior would have the advantage for central bankers to make oil and commodity prices fall. This fall would then cause a fall in prices and a slowdown in inflation in the end.
As you can see, for the central bankers to make this sharp turn, they are going to pilot with mastery. This will not be easy. But from time to time, it is interesting to put forward an optimistic scenario, rather than constantly predicting an upcoming exit.
To be continued in the coming weeks and months.
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