wvbankers.org 12 West Virginia Banker The Fed’s Balancing Act On the first trading day of 2022, the U.S. 10-year Treasury Note yield jumped above 1.60%, then traded up another 10bps in the two subsequent sessions. That was a 35bps 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 overheated economy where everything is maxed out and hitting on all cylinders, and strong demand is pulling up the general price level. That is not really what is happening now. Instead, we’re dealing with “supply shock” inflation, where COVID-induced shutdowns produce bottlenecks and sclerotic trade flows. Dockworkers, 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 a tighter monetary policy the right medicine for “supply shock” inflation as is normally the case with “demandpull” inflation? Or might a higher cost of borrowing just 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 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 inflation really is just a matter of temporary supply chain problems, they run the risk of creating recession to little purpose. The Fed needs to go slow if the inflation trend is truly benign. But if it has deeper, more fundamental roots, too gradual a policy would Short-term yields have risen commensurate with the expectation of multiple rate hikes. All members of the Federal Open Market Committee (FOMC) now see at least one, and some see as many as four hikes in 2022. By Jeffrey F. Caughron, The Baker Group for 2022
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