Is the global economy entering an era of ‘Great Volatility’?
Federal Reserve Chairman Jerome Powell’s remarks at the Jackson Hole meeting grabbed headlines two weeks ago. His message was clear: The Federal Reserve must persevere in bringing inflation under control even if the U.S. economy and labor market weaken. It disappointed investors who were hoping the Fed would pivot from tightening monetary policy, and the stock market has sold off in the meantime.
In his remarks, Powell acknowledged that the current high inflation is the result of strong demand and constrained supply, and that the Fed’s tools work principally on aggregate demand. But he maintained that, “None of this diminishes the Federal Reserve’s responsibility to carry out our assigned task of achieving price stability.”
Still, many observers question whether it is appropriate to tackle global supply shocks by raising interest rates significantly. In their view, the Fed could be making a policy error that will damage the economy and result in significant job losses.
But the skeptics should read the remarks of another Jackson Hole participant — Isabel Schnabel, a member of the Executive Board of the European Central Bank (ECB). She makes the case for central banks to tighten monetary policy now even as the global economy is weakening. Indeed, the ECB raised rates by 75 basis points this week despite concerns that the EU is headed for a recession, and the Fed is expected to do the same at the upcoming Federal Open Market Committee meeting.
Schnabel’s thesis is that the global economy is transitioning away from the
“Global Moderation” that was accompanied by economic prosperity and relative macro stability for three decades. During this period, central banks played an important role by successfully targeting low inflation, which increased the confidence of households and businesses.
By comparison, the past three years suggest we may be entering a period of “Great Volatility” as the global economy has been buffeted by the COVID-19 pandemic, Russia’s invasion of Ukraine and the effects of climate change. Schnabel argues that while these forces will likely lead to weakness ahead, the decisions that central banks take to address high inflation can mitigate and limit the ultimate impact of these shocks.
Schnabel believes central banks face a choice of proceeding with caution (viewing monetary policy as the wrong medicine for supply shocks) or of determination by moving forcefully even at the risk of lower growth and higher unemployment. She favors the latter approach for three reasons.
First, uncertainty about inflation requires a forceful response. If inflation stays high for too long, Schnabel claims it is irrelevant whether the cause is supply or demand. She argues that by acting early when inflation accelerates, policymakers can lessen the risk of having to take Volcker-like actions later.
Second, the risk that inflation expectations will become de-anchored threatens to undermine the credibility of central banks. She notes that the surge of inflation has started to lower the trust in institutions and that young people have no memory of central banks fighting inflation. She also flags the rise in inflation expectations that is occurring now in Europe.
Third, Schnabel contends that central banks are facing a higher “sacrifice ratio.” That is, the potential cost of acting too late and allowing inflation expectations to become entrenched means that more severe action will ultimately be required with worse consequences, such as occurred in the 1970s and early 1980s.
In the end, Schnabel sees the challenges that central banks face today as potentially prolonging the Great Volatility or rendering the pandemic and war with Ukraine as a temporary interruption of the Great Moderation.
This assessment provides a basis for the Fed and other central banks to raise interest rates, but it still leaves open a key issue: Namely, by how much would the U.S. unemployment rate have to rise before the Fed backs off?
There is no simple answer to this question, because it will ultimately depend on how the economy and inflation fare in the future. The Fed’s current projections call for only a modest increase in the unemployment rate, to 4.1 percent by 2024, to bring inflation under control. But former Council of Economic Advisers Chairman Jason Furman notes that a scarier forecast published by the Brookings Institution concludes the unemployment may need to reach 6.5 percent to bring inflation back to the average target rate of 2 percent.
On this score, it’s easier to assess what bond investors are thinking. Following the Jackson Hole meeting, the bond market is pricing in the Fed funds rate peaking at about 4 percent in early 2023 and then declining gradually. This represents only a marginal change from the level that was priced in previously.
My take, however, is that investors have consistently underestimated inflation in the past two years, believing it has been entirely linked to the COVID pandemic, while ignoring the impact of stimulative monetary and fiscal policies. Accordingly, the risk is that the funds rate will peak beyond 4 percent and most likely end up at 5 percent – 6 percent.
Whatever the outcome, I hope the Federal Reserve now understands that backing off from policy tightening prematurely can result in a worse outcome. It’s time to end the “Fed put,” in which investors perceive that the Fed will ease policy whenever the stock market sells off noticeably. This response has contributed to frequent asset bubbles since the 1990s. Rather, the Fed’s focus should be on reining in inflation and inflation expectations, as policymakers have declared.
Nicholas Sargen, Ph.D., is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books, including, “Global Shocks: An Investment Guide for Turbulent Markets.”
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