Inflation figures in the United States and much of the world continue to hit highs not seen in nearly four decades.
The expectation of many specialists is that, by this time of year, inflationary pressures should have begun to give up some ground.
This expectation was based on the fact that, as of May, the bases of comparison would become easier since the upward trend in prices began with greater force from the second quarter of last year (annual inflation went from 1.7 to 5% between February and May last year).
Although the base of comparison in June will be a bit easier – annual inflation in June 2021 was 5.4% – the bases of comparison do not really improve until the last quarter of the year (annual inflation in the fourth quarter of 2021 average 7 percent).
Given this scenario, the Fed and the markets have been constantly revising their inflation expectations for the end of this year upwards. This strong upward revision of inflation expectations has been logically accompanied by a considerable increase in expectations for interest rates and a strong downward revision in economic growth estimates.
This situation has led a growing number of specialists to wonder if the Fed will be able to achieve a soft landing for the US economy. The “soft landing” involves bringing down inflation by tightening monetary policy, but without triggering a recession.
In the opinion of a growing number of specialists, the probability of a soft landing has been diminishing as it has become more evident that the Fed made monetary policy mistakes that it must correct.
It is true that inflationary pressures began with an exogenous supply shock following the impact of the pandemic on global supply chains and that this shock was amplified by the Russian invasion of Ukraine. It is also true that the Fed had nothing to do with these exogenous shocks. However, the Fed seems to have made a mistake in failing to recognize the magnitude of the inflation problem in time.
Although the Fed had nothing to do with the supply shock, its monetary policy decisions did have a lot to do, in conjunction with fiscal stimulus, in artificially stimulating aggregate demand. The error in the diagnosis contributed to the Fed maintaining monetary stimulus for too long.
Now, the Fed must correct the path and withdraw the stimuli in an accelerated manner. This implies tightening monetary policy in a sharp, and potentially disorderly way, rather than gradually.
In this sense, the Fed has lost credibility because it has had to constantly change its framework for macroeconomic estimates and future guidance on interest rates.
It is worth remembering that in less than six months the Fed has modified its 2022 macroeconomic framework significantly, increasing its guidance for the funding rate from 0.9 to 3.4%, while its inflation estimates increased from 2.6 to 5.2% and those of growth were cut from 4.0 to 1.7 percent.
A Fed with low credibility makes the market question its projections and therefore its responsiveness and effectiveness in terms of monetary policy. What makes the Fed’s task more complex is that the labor market is at full employment.
Although the Fed has no control over the disruptions in the supply chains or in the prices of energy and food raw materials, the loss of credibility and the situation of full employment in the labor market means that the inflationary shock, generated by the of the offer, could contaminate the processes of wage negotiations, pushing wages up and helping to entrench the cycle of inflationary pressures.
The three main economic blocs at the global level (United States, Europe and China) are in a process of simultaneous slowdown that could be exacerbated if inflationary pressures do not subside and central banks are forced to restrict monetary policy beyond what they have guided.
Managing Partner of EP Capital, SC
Without Borders
Joaquín López-Dóriga Ostolaza is the Managing Partner of EP Capital, SC, a consultancy specialized in mergers and acquisitions founded in 2009.
He is a graduate of the Bachelor of Economics from the Universidad Iberoamericana, where he graduated with honors and the highest average of his generation. He has a Master’s degree in Economics from the London School of Economics, where he was awarded the British Council Chevening Scholarship Award.