New record inflation against the backdrop of a tight labor market and rising food and commodity prices, despite the recent drop in oil and thus gasoline prices, will leave the Fed with no choice but to continue raising interest rates aggressively, even if threatens to put the US economy into recession.
In fact, the decline in oil prices — they fell Tuesday for the first time since they temporarily plunged below $100 a barrel in April — also reflects traders’ view of commodities markets that a recession and reduced demand is imminent. †
With inflation at unprecedented levels and monetary policy such crude instruments, it is almost inevitable that the [Fed] will have to cause a recession to get inflation under control.
There are those, including the Fed, who believe that, because of their imperfect track record in forecasting recessions, the two-year/10-year inversions are less useful as a guide to the economic future than the three-month/10-year rate relationship, where inversions were perfect predictors of past recessions.
That relationship has not yet reversed, but the premium for 10-year bonds over 3-month Treasuries has tightened dramatically, from 234 basis points in May to about 80 basis points.
What bond investors tell us is quite rational. The Fed has no choice but to keep raising interest rates until it is convinced that inflation will fall back to its target of about 2 percent, which will lead to a rise in unemployment and a fall in demand in the economy.
With inflation at unprecedented levels and monetary policy such crude instruments, it is almost inevitable that the central bank will have to trigger a recession to try to control inflation.
This has unintended consequences for third parties. Indeed, it is already having an effect.
The euro, for example, is at its weakest level against the US dollar in 20 years and only a fraction of parity.
That’s partly because higher rates in the US are attracting capital flows due to better returns compared to Europe or Japan. But it is also because there is an element of a flight to safety due to the expectation that the tighter monetary policies now being pursued by most central banks around the world will lead to a global recession.
A weaker currency is good for exports, making it more competitive, but it imports inflation — goods bought in US dollars cost more in local currency – and increases the cost of paying off US dollar-denominated debt.
Europeans are concerned that while a weaker euro is beneficial for an export-oriented economy like Germany, it will increase pressure on over-indebted economies like Greece and Italy and, perhaps even more threateningly, increase the cost of energy for a region already experiencing a deepening energy crisis as Russia continues to curtail gas supplies to Europe. Oil and gas are, of course, mainly traded in US dollars.
The war in Ukraine, rising energy costs, the sharp loss of purchasing power of the weaker euro and the reaction of the European Central Bank to the high European inflation figures almost guarantee a nasty recession in Europe.
‘Crisis on crisis’
In Australia, the slump in the value of the Australian dollar to around 67.5 cents (it was close to 76 cents in April) is good news for our commodities businesses and the federal treasury, as they will help mitigate the effects of weaker commodity prices. But it will add to the inflation challenge – and the pressure for higher interest rates – facing the Reserve Bank.
International Monetary Fund director Kristalina Georgieva warned of a global debt crisis on Tuesday as global financial conditions tighten, describing the projected rise in debt service costs as a “crisis upon a crisis,” with the third shock of surges. of the cost of loans after the effects of the pandemic and the war in Ukraine. About 30 percent of developing and emerging countries are in or near debt, she said.
Freeing developed economies from unsustainable levels of inflation will therefore come at a significant cost to the global economy, although some economies will be more affected than others.
For the central bankers, however, there is no alternative. In many ways, a purge of the excesses, imbalances and unproductive incentives they created with their unconventional monetary policies since the 2008 global financial crisis has been almost inevitable and inevitably painful, but necessary.
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