As the Federal Open Market Committee of FOMC meeting ends today, the federal reserve is widely expected to raise interest rates by 50 basis points. Inflation, thought to be transitory all of last year suddenly seems to be more permanent. For the past 14 years, the world has been awash with reserve bank liquidity, 0 interest rates and bond/asset buying on an unprecedented scale. According to the attached article, USD 8 Trillion was added in just the last 2 years post the pandemic. The G7 countries plan to reduce their central bank balance sheet by only USD 410 Billion by the end of this year, a relatively small amount. So why is the market on edge about this interest rate increase?
The US Federal Reserve plans to roll off USD 95 Billion a month, which means it will simply stop buying government bonds. This means that other players in the market will have to step in to buy Treasury Bonds but the returns they will expect will surely include a higher risk premium, especially for longer dated bonds. The Federal Reserve is still not planning to sell the mortgage backed bonds and other outright assets it purchased which will still remain on their balance sheet and provide support to the market. The cost of supporting Ukraine in the war against Russia is huge. Congress has been asked to approve military equipment aid bills to send equipment to Ukraine. That will require more spending which will offset any Fed balance sheet reduction.
Higher gasoline prices will hit demand and reduce consumption, especially for lower income families but inflation pressures will remain high. First is the covid related lockdowns in Beijing and Shanghai. Due to the lockdowns ports are unable to operate and supply chains are effectively blocked. Production and delivery delays will cause shortages for almost all items linked to China based production. The Ukraine war has raised energy prices across Europe. If Russian gas and oil are effectively embargoed, then getting suppliers from other sources at higher prices also acts to boost inflationary pressures. Any rise in energy costs feeds into almost every other commodity in the form of transportation costs. The Ukraine war has also hit food supplies hard. Ukrainian wheat which comprised approximately 20% of global supply is not available for the time being. Central banks are caught between a rock and a hard place.
Labor costs are also rising. Companies are unable to find workers. Covid forced many experienced workers to find alternative work and many have left their previous industries permanently. Lower paid workers are demanding wage increases to make ends meet as inflation eats into their meagre earnings. The inflation pressure is real now and the central banks cannot afford to let inflation run rampant. But at the same time multiple external shocks limit their ability to contain inflation without raising interest rates which eventually may lead to a recession. We are well and truly into stagflation.