18 MARCH / APRIL 2022 The Fed’s Balancing Act DIRECTORS / SENIOR MANAGEMENT Jeffrey F. Caughron Chairman of the Board The Baker Group jcaughron@GoBaker.com The Baker Group is a Preferred Service Provider of the Indiana Bankers Association and an IBA Diamond Associate Member. On the first trading day of 2022 the U.S. 10-year Treasury note yield jumped above 1.6%, then traded up another 10 basis points in the two subsequent sessions. That was a 35-bps increase in two weeks and aligned with a similar move higher for market measures of inflation expectations. The bond market hadn’t seen a worse start to a year since 2009. It seems the market is entering the new year with the same concerns and uncertainty that plagued it for most of 2021, but with greater urgency. We’ve seen this movie before, though, and it’s clear that policymakers and investors alike need to carefully assess the strength and staying power of an inflation environment that’s unusual, but not-so-transitory. Typically, an inflationary impulse arises late in an economic cycle and is driven by an overheating economy in which everything is maxed out, hitting on all cylinders, and strong demand is pulling up the general price level. That is not what’s happening now. Instead, we’re dealing with “supply shock” inflation where COVID-19-induced shutdowns produce bottlenecks and sclerotic trade flows. Dock workers, truck drivers, processing personnel and other key points in the supply chain are working with reduced staffing and capacity, causing ripple effects throughout the system. So, are rate hikes and tighter monetary policy the right medicine for supply shock inflation, as is normally the case with “demand pull” inflation? Or might a higher cost of borrowing exacerbate the supply chain disruptions? Former Treasury Secretary Lawrence Summers recently warned of a trying period for the U.S. economy in coming years with a risk of recession followed by stagnation. He voiced fears that “we are already reaching a point where it will be challenging to reduce inflation without giving rise to recession.” Fed decision-makers are all too aware that if they move too aggressively, and if inflation really is a matter of temporary supply chain problems, they run the risk of creating recession to little purpose. The Fed needs to go slowly if the inflation trend is truly benign. If it has deeper, more fundamental roots, however, too gradual a policy would allow inflationary psychology to become embedded in the economy, risking a wage-price spiral and pushing households and firms to get ahead of assumed cost increases by resorting to stockpiling. That’s the Summers worst-case scenario: a return to 1979. There can be no question that the Fed is right to accelerate the “tapering” and stop pumping liquidity into an over-liquified banking system. In their zest to prop up the economy way back when COVID-19 was new, Fed decision-makers characteristically overdid the job, creating way too much cheap money, distorting financial markets, and fueling asset price bubbles in speculative assets that pose serious risks going forward. The quantitative ease needs to stop. That’s the easy part of the Fed’s task. The hard part is subsequently determining when and how fast to raise rates. The flattening yield curve is a reflection of the dangerous waters the Fed must navigate. Short-term yields have risen commensurate with the expectation of multiple rate hikes. All members of the Federal Open Market Committee now see at least one, and some see as many as four hikes in 2022. Longer-term yields, though, have behaved differently. Despite the new year’s jump, the 10-year yield remains below its March 2021 high of 1.75%. That may change, of course, but the fact that yields in the long end have moved so slowly up to this point has allowed the yield curve to flatten and belies genuine concern about growth going forward. The Fed is indeed walking a tightrope. Let’s hope it’s able to keep its balance. HB
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