The Fed is ready to choke the US economy to kill inflation

The Fed’s new-found aggression means it is likely that it won’t just be the US that flirts with recession. Most other major central banks are raising rates and siphoning liquidity out of their systems.

Europe, with its particular challenges as a result of Russia’s invasion of Ukraine, is destined to experience shrinking economies even though it badly lags the Fed in raising its policy rates. China’s economy has faltered badly and is stalling because of its COVID policies and the implosion of its property markets.

The simultaneous slowing of the world’s three biggest economies and the global tightening of monetary conditions that the Fed is now leading makes it increasingly likely, perhaps inevitable, that there will be a global recession.

The US dollar spiked again after the Fed’s announcement, to 20-year highs against its major trading partners. It is up about 16.5 per cent against a basket of those currencies this year, placing significant pressure on other central banks to adopt more aggressive monetary policies to defend their currencies and minimise the inflationary effects of currency depreciation.

The Australian dollar is now trading just above US66 cents. A month ago, it was still above US70 cents and as recently as April it was above US75 cents.

By trying to play catch up with an inflation rate that was already entrenched the Fed has been left with no palatable alternative but to choke off inflation by choking the US economy.

The pace and extent of that fall adds to the pressure on the RBA to keep raising the cash rate. The Fed may not dictate global monetary policies, but it heavily influences them via the interest rate differentials and currency relativities.

It also impacts other global financial markets.

Wall Street fell, again on Wednesday, after concluding that the Fed was singularly focused on bringing down the inflation rate and that orchestrating a soft landing is now a far lesser priority.

The FOMC projections make it clear that the committee expects US rates to keep rising and remain higher for longer. The media projection for the federal funds rate in 2024 is 3.9 per cent and even in 2025, it would still be 2.9 per cent and therefore still above the Fed’s targeted inflation rate of 2 per cent.

For sharemarkets that value companies on their discounted future cash flows, the rise in the yields on inflation-protected 10-year Treasury bonds is threatening. Where, at the start of the year, the discount rate – the real 10-year bond rate — was negative, now it is solidly positive. That will impose even greater pressure on the value of high-earnings-multiple stocks, particularly technology stocks.

The S&P500 fell 1.7 per cent after the rate increase – it’s down 21 per cent this year – and the Nasdaq index, with its bias to technology companies, 1.8 per cent. It is down about 30 per cent this year.

The bond market also reacted sharply to the Fed’s announcement, with the yield on two-year Treasuries climbing through the 4 per cent mark last breached in 2007.

It reached 4.05 per cent on Wednesday as traders concluded that there would be no Fed “pivot” — a switch from tightening policy to loosening it as the economy slows – within the next year or so.

The optimists in the market had been pricing in a peaking of US rates by the end of this year or early next year at the latest. Powell’s commentary and the Fed’s famous “dot plot” of FOMC members’ projections, which show the federal funds rate is still expected to be close to 4 per cent in 2024, dashed their hopes.

With the markets now being led by Powell and the Fed to expect at least one more of the supersized 0.75 percentage point rate increases this year, along with either a fifth of that size or at least another 0.50 percentage point, the outlook for the markets (and the economy) is bleak.

Monetary policies are crude tools that impact with lags of uncertain duration. It’s not surprising that Powell declined to rule out the prospect of a recession as a result of the Fed’s policies.

By trying to play catch up with an inflation rate that was already entrenched (partly attributable to overly loose monetary and fiscal policies and partly to the impact of the pandemic on global supply chains), the Fed has been left with no palatable alternative but to choke off inflation by choking the US economy. It seems to have finally accepted that.

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