Recalculating route. The GPS of the Federal Reserve is looking for the path that will allow it to curb inflation without causing a recession, but the path is getting narrower. The pressure on prices does not give up and in May its annual rise marked a new maximum of the last 30 years, with 8.6%. After that data, published on Friday, economists see it very likely that the Fed will raise rates more aggressively than expected until now.
The first step can be seen in the two-day meeting that starts today. In May, after approving a 0.5-point rate hike, the largest in 22 years, Federal Reserve Chairman Jerome Powell indicated more specifically than usual that the committee was planning two more half-point hikes in June and July meetings. However, the market has begun to bet on a rise of 0.75 points, the highest since 1994, as the most likely result of the meeting (some even speak of a point). For central banks, being predictable has become an asset. They try to anticipate where their movements are going to go to avoid scares and distortions in the markets, but it is not always possible.
Actually, in fact, the market has already adjusted its expectations. The sharp drop in the stock market is a clear symptom that mixes fear of higher interest rates and lower growth. The dollar has strengthened and is trading again in the area of maximums of the last 20 years against the main currencies, punishing the results of US multinationals. But where there has really been a swerve that has to do almost exclusively with interest rate expectations has been in the debt market. Three-year US Treasury rates have soared, posting the biggest two-day rise since 1987, according to data from Bloomberg. They have passed in two sessions from 3% to 3.49%.
In the money market, interest rate derivatives, which more accurately measure market expectations of policy rates, show that investors expect the fed funds to be at 4% by the middle of next year from the level of 0.75%-1% in which they are now. The probability that the market grants a rise of 0.75 points this week is at least 50%. The markets are therefore ready. If the Fed does not want to cause surprises, a rise of 0.75 points has almost ceased to be so, although there are also those who consider that it can maintain the rise of half a point this week and move the most aggressive rises to July or September.
Not even the greats of Wall Street have it clear. While for the chief economist for the United States of JP Morgan, a rise of 0.75 points is most likely and the possibility of a rise of one point is a non-negligible risk, the head of global economic analysis at BoFA Securities, Ethan Harris believes that the rise will be 0.5 points, according to two reports sent to clients on Monday. Of course, Harris predicts that Powell will adopt a tone in the fight against inflation “whatever it takes” (“whatever it takes”, in reference to the words of the then president of the European Central Bank, Mario Draghi, in 2012 to save the euro).
He knows in depth all the sides of the coin.
The problem is that what may be needed is a recession. Or, more accurately, what is needed to curb inflation may be rate hikes that end up causing a recession. The rise in interest discourages companies and consumers from borrowing, makes loans more expensive, cools the real estate market and, in short, slows down the economy.
The CEO of Morgan Stanley warns: “There was a risk of recession. I used to think it was 30%. Now it is more like 50%, but not 100%. You have to be a little cautious.” In his opinion “it was inevitable that this inflation would not be transitory, it was inevitable that the Fed would have to move faster than they were projecting,” he said at a conference on Monday. His colleague Jamie Dimon, from JP Morgan, already warned weeks ago that he saw an economic hurricane coming.
In the markets there is another sign of this risk: the inverted rate curve. Normally, interest rates on debt are lower in the short term and higher in the long term, since the risk is greater in the long term. Putting the interest rates at different terms on a graph, they usually show an ascending curve. Sometimes, however, the curve turns around. That inverted curve, at least in some terms, is interpreted by the market as an indicator that a recession is coming (and that with it, when inflation is controlled, rates will have to be lowered again).
In the United States, this Monday, the interest rates of the 3-year public debt were higher than those of the 5-year debt, in turn above the 10-year debt and these, also above the debt to 30 years, although the difference between the first (3.49%) and the last was scarce, which showed a rather flat curve.
Part of the price increases have to do with the reactivation of demand, but there are others that are exogenous or the result of supply problems and it is not clear that rate increases are very effective in combating it. For example, gasoline prices are skyrocketing as a result of the rise in oil, mainly. The gallon (3.78 liters) has exceeded 5 dollars on average for the first time in history in the country as a whole, but in California it has reached around 8 dollars, prices never seen before.
The nightmare scenario would be stagflation, that is, stagnation with inflation. Rate hikes may bring the economy to a halt, but that may not be enough to achieve price stability. The political implications of the price increases are already being disastrous for the popularity of the president of the United States, Joe Biden, and for the expectations of the Democrats before the legislative elections in November, in which a little more than a third of the Senate is renewed and the entire House of Representatives. If you add to that an economic slowdown, things can be even worse.
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