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Fed policy stuck between a rock and a hard place

A few weeks ago, there was still reasonable debate about whether the United States would soon begin to peak. Whatever the merits of the argument, it has been shattered by the economic backlash of the war in Ukraine.

The central bank now faces tough monetary policy choices that can only be described as choosing the least of the wrong options as a perfect storm of macroeconomic conditions triggered by the war in Ukraine sweeps across the world.

Part of the Fed’s predicament has to do with leaving monetary policy too loose for too long and assuming that the recent rise in inflation would be “transient”. There are signs that the supply chain disruption is easing, which has been/still responsible for a significant portion of the sharp increase in price pressure to date. As recently as mid-February, this story had success. But that’s mostly a moot point now because a war-related energy shock is driving up inflation.

Yesterday’s news that US consumer inflation continued to rise in February is particularly worrisome as the acceleration continues not yet reflect the Ukraine effect. The headline CPI rose 7.9% year-on-year to last month, a new high in 40 years.

Historical CPI and Core CPI chart

The challenge for Fed policy is easily summed up by comparing current interest rates to inflation. Even before the Ukraine shock is fully absorbed by prices, the Fed is well behind the curve with a target rate of 0% to 0.25%. Using core CPI as a benchmark, the fed funds rate is about 6 percentage points lower than inflation. This is a dramatic decline, and it is almost certain to widen in the near term as the Ukraine-related supply shock ripples through the global economy.

Notably, the Treasury market is heading into this new world order with current yields that do not reflect the rapidly changing terrain of inflation. For a quick look at the state of the disconnect, consider how the current — 1.98% as of March 10 — compares to history vis-à-vis core consumer inflation.

Core CPI/Treasury 10-Year Yield

Core CPI/Treasury 10-Year Yield

Using the 60-year relationship and the 10-year rate suggests that the Treasury market is significantly undervaluing inflation. There are several ways to interpret this, starting with the idea that the market will come under strong pressure to increase yields (i.e. reduce bond prices sharply).

Another view is that the market is still pricing in a forecast that the surge in inflation will subside at some point in the near future. While there’s still a case for this scan, it’s only relevant if your time frame is extended (compared to the assumption a few weeks ago). In the long term, the forces that created a strong trend of disinflation will resume. But for the foreseeable future, these forces are on standby (if not on a large scale) in the face of war-related inflationary pressure. Indeed, the Treasury market’s implied inflation forecast is being revised upwards again, sharply, as shown in the next chart below.

5- and 10-year inflation forecasts

5- and 10-year inflation forecasts

Deciding when the forces of disinflation will return to dominance has become an unusual challenge since Russia invaded Ukraine. Several major macroeconomic forces are currently under severe pressure, including globalization and energy supply. The uncertainty of the war makes forecasting the return of something approaching “normal” macroeconomic conditions very hazy at this time. As a result, markets are likely to demand a deeper discount for this surge in uncertainty, i.e. higher yields in the Treasury market.

In fact, there are many facets to uncertainty. On the one hand, there are strong arguments for a tougher Fed policy to deal with soaring inflation. But the shock wave of higher energy prices increases the risk that economic growth will slow, perhaps to the point of tipping the economy into recession. On this basis, the Fed could decide to slow down and/or delay rate hikes.

Adjusting the calculation of what is likely and what is not will, until further notice, be a game of hour-by-hour, day-by-day reassessment of risk factors as the war in Ukraine unfolds. takes place. Since no one knows how the conflict will evolve or how the global repercussions will play out, adjusting Fed policy has rarely been more difficult or error-prone. It may be too extreme for the central bank to fly blind, but according to the relevant metaphors, it’s pretty close.

The risk of a policy error, in short, is high. Unfortunately, the economic stakes are too, perhaps for years to come.