December 7, 2022

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- The biggest challenge is inflation - E24

– The biggest challenge is inflation – E24

The Fed should lower inflation, but it will avoid the economy falling into recession. DNB Markets believes that it may be more difficult than before.

Jerome Powell’s weapon against “too high” inflation is to raise interest rates. Now he must find out how aggressively the central bank will act.
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Inflation is too high and the US Federal Reserve must act quickly to bring monetary policy back to a more neutral level.

That was the message Governor Jerome Powell sent when he spoke at a conference in Washington on Monday night.

His goal is to raise interest rates and lower inflation, while facilitating economic growth and a strong job market in the wake of the virus measures. This is called a “soft landing”.

In the speech, Powell asked himself the following questions:

“How likely is it that monetary policy can reduce inflation without causing a recession?”

Powell said there is some reason for optimism here, because a relatively easy landing was not unusual in the United States. He cited three cases: 1965, 1984 and 1999. During these years, the Federal Reserve raised interest rates dramatically without a recession.

But these three cases differ from the current situation, notes chief economist Knut A. Magnussen at DNB Markets.

– The biggest challenge now is eight percent inflation – while it was lower in all three cases. He says unemployment was higher.

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– It could be more difficult

The technical definition of a recession is two consecutive quarters of an economic downturn.

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On a note, the DNB Markets economist notes that the risks of this are likely to increase.

This time around, it will probably be more difficult to curb inflation by moderately raising interest rates. If the proposed strategy fails, and the Fed is forced to rise more aggressively over a longer period, we believe the risk of a recession will increase, he wrote in a note.

He explains to E24:

– It’s a matter of “tuning” the machines. Powell said interest rates are a rather slow and not very accurate tool, and when inflation is as high as it is now, the risk is to take very drastic action and eventually update it.

Sharper increases in interest rates will cause a sharp decline in financial markets and increase credit spreads and borrowing costs for both businesses and households. House prices can fall if interest rates go up, and then housing wealth is affected for many – and this particularly affects families.

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flat yield curve

During the speech, Jerome Powell opened for larger rate increases than previously announced, if necessary.

Help raise interest rates on US government debt. Those rates have actually gone up since the start of the year because the market is already anticipating a rate hike from the Fed.

At the same time, the difference between long-term and short-term interest rates has narrowed. This phenomenon has a bad reputation.

Because when short-term interest rates exceed long-term rates – the so-called yield curve inversion – the market often interprets this as a signal of an impending recession.

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When the Fed has to tighten, market participants realize it could be too much, and then long-term interest rates go down because things can go badly in the economy. At the same time, Magnussen says, short selling is maintained by an interest rate hike.

The coup has not yet occurred. On Tuesday night, the spread between the ten and two-year bonds was about 0.2 percentage points.

Historically, an inverted yield curve has been a good sign of a recession, but it often takes a while for it to actually materialize.

– Then it doesn’t always make sense. It happened Before the pandemic, but it has nothing to do with monetary policy.

The Fed already has plans to shrink its balance sheet and the bonds it owns. In this regard, the Fed could try to influence the market and push long-term interest rates higher, Magnussen says:

– It will be able to prevent the coup, but it will slow down the economy.

He believes that the central bank will in any case have to deal with high inflation – and that a possible reversal will not change its policy.

– They can’t “retreat”, even if they see that things are going this way.

Three years – two percent

Last week, the central bank raised interest rates for the first time since 2018, indicating six more increases this year — and three next year.

However, after Monday’s speech, DNB Markets expects larger rate hikes compared to the previous list.

– The road gets a little longer as you go. Now there is a need to get a lift, and they are clearly already late. Then they have to work radically at first, Magnussen says.

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Bigger interest rate increases (say by 0.5 percentage point) could come at the next meeting in May – and possibly June, the brokerage believes.

Meanwhile, Powell said he believes inflation will fall to 2% over the next three years.

After all, there’s plenty of time to do it, and there’s an argument for trying to do it incrementally, says Magnussen.

Therefore, DNB Markets believes the interest rate jump will be 0.25 percentage points from July onwards – until the rate could finally rise to around 3.5 percent in the summer of 2023.