Will Fed chicken out of rate hike?

You can bet that US President Joe Biden expected better news out of Nato than its secretary-general Jens Stoltenberg admitting that the Russia-Ukraine war could linger another year, perhaps even longer. The wretched conflict has clearly gone terribly off-course for everybody. Sure, Russia miscalculated and didn’t take Kyiv “in a day or two”, as Kremlin hardliners boasted on the eve of the invasion.

But then all the sanctions imposed by the European Union (EU) and the United States (US) have not intimidated the Russian bear enough to retreat into his cave either. They seemed convinced that excluding prime Russian banks from the SWIFT network, isolating them from financial markets and limiting their ability to conduct international transactions, would be the last straw. But it didn’t work as well. Sure, Russia’s economy is suffering, but not enough to roll everything back and spread the red carpet for Nato right in its backyard.

Countries that have nothing to do with the war are suffering as well because supply shocks and sanctions have created a commodity super-cycle not seen since the 1970s drew to a close more than 40 years ago. That explains why more than 60 central banks have raised rates so far this year; and this is just the start of the process.

Yet Biden’s biggest worry lies inside the US. The war started just when the Federal Reserve was putting the final touches on its strategy of turning around the interest rate cycle. And on top of everything already pushing up prices, much of which the Fed must have priced in, came the explosive impact of the war that pushed US CPI stated rate of inflation to a 40-plus-year high of 8.6 percent. That’s confounded the hawkish cycle practically just as it began, forcing the kind of one-time raises not seen in decades.

The market does expect prices to fall in the near term because they’ve been inflated as part of the effort to rescue the US economy from Covid. But this is transitory and it would be wrong to think in quarters. Because the real inflationary pressures have little or nothing to do with the real economy, they have to do with quantitative easing, effects of debt and deficits and, above all, effects of negative real interest rates. And these pressures will not go away in a hurry.

Old-timers in financial markets will tell you that these inflation and interest rate trends are eerily reminiscent of the 1970s, when the last big commodity super-cycle was unfolding. Then, just as now, people didn’t initially realise how hard the hammer was going to fall on their earnings and savings because of the habits developed in the two rather benign decades before it. But once they realise how 8.6 percent inflation against 50 basis points or so yield on their savings portfolio impacts the spending power of their retirement, they will go into shock very quickly. And it won’t help, of course, when they understand that over four years the spending power of their retirements has dropped about 25 percent.

That ought to quickly change the four-decade trend of buying bonds for retirement plans as investors rush to more inflation oriented portfolios; not something people have thought of since the ‘70s, when investors wouldn’t show up for US treasury auctions. Now you can’t just count on a painful yet relentless hike, like Paul Volker did when he raised rates from 5.5 percent to 15.5 percent. Because when he did it the US federal government debt to GDP ratio was around 25 percent, now it’s 110 percent.

Negative real interest rates are the biggest thorn in the side of the Fed as well as the White House. A few statistics are quite sobering. In the last four decades, the US 10-year Treasury rate has recorded a positive yield after CPI stated rate of inflation, which is above 8.5 percent right now. That, historically, would require the 10-year Treasury rate to be at least 9 percent, which would triple interest on federal, state and local debt.

Also, traditionally the US 30-year fixed mortgage rate has traded at a premium to 10-year Treasury notes, which means it would have to go up to about 9.5 percent. You don’t even have to imagine how such a scenario would traumatise young would-be home buyers; the lynchpin of the US economy. Positive interest rates would no doubt cure inflation, but they would play havoc with all sorts of balance sheets before they are able to do it. And, even before rates get to positive yield, they would extract far too big economic and political costs for the presidency or the Fed to keep tightening monetary policy. That explains why there is increasing chatter now that the Fed, and the federal government, might chicken out before interest rates turn positive considering the pressure on the economy and the voters.

Biden must be livid that on top of everything else, Vladimir Putin’s war and the politics around it are causing supply disruptions that are pushing prices even further up. The only way to manage the rest of the year at least, short of calling off Nato’s provocative expansion and effectively ending the war, is engineering a recession in the US economy to save it from runaway inflation because monetary policy seems to be about to hit a rough patch very soon.

Copyright Business Recorder, 2022