Dancing to the Fed’s tune

12 August 2022

Two years ago, at the annual Jackson Hole economic symposium, US Federal Reserve (Fed) chair Jerome Powell announced a new monetary policy framework which involved two key changes. The first was that if US inflation ran below 2% for some time, the Federal Reserve would allow inflation to run “moderately” above its target as long as it could keep inflation about there for an “average” over a period of time. The second change was to ensure full employment by only responding to a tight labour market when signs of inflation became evident. In other words, the Fed would not react to a tightening of labour conditions by means of pre-emptive rate hikes but would rather fall behind the curve until inflation became clearly evident. Unfortunately, such vague language only served to sow the seeds of uncertainty for market participants.

By the end of last year, US unemployment had fallen below 4% but total employment was still below pre-pandemic levels as many workers reconsidered their options. Many workers who did not have the luxury of working from home and who remained hesitant to return to work due to the new variants of the Covid virus either decided on new careers or exited the workforce completely leading to the so-called great resignation.

Perversely, a combination of strong stimulus, government benefits which boosted household savings and record low interest rates saw US inflation hit forty-year highs passing the 7% mark in 2021. To make matters worse, global supply chains were still struggling to get back to normal, with car production globally hitting the brakes. Finally, the Fed members opted to end asset purchases by March 2022, opening the door for rate hikes in that year.

Powell’s flexible average inflation targeting (or FAIT) appeared to have failed. And yet US President Joe Biden chose to renew Powell’s term for four more years. The war between Ukraine and Russia only served to pour oil on the inflationary fires. This forced the Fed to pull the emergency handle in June with a jumbo rate hike of 75 basis points, the largest since 1994.

Some in SA may ask, “What has all this got to do with us?”. It would indeed be a good question since the South African Reserve Bank (SARB) has been ahead of the curve, starting its rate hiking programme last November well before their American counterparts. But since then, our own central bankers appear to be playing catch up, hiking 50 basis points in May and then 75 basis points in July, in lockstep with the Americans. With the Fed having opted for a second 75 basis points hike in July and another strong US jobs report last Friday, the risk is that the US central bank may be forced to follow in the same vein at its next meeting in September. This mean that the SARB has to make the difficult decision to continue this “dance macabre” on 22 September 2022.

The Americans though appear to enjoy one clear advantage over us. The Fed, for now, has accumulated sufficient credibility to have its bond market dance to its tune. The US 10-year treasury yields peaked at close to 3.48% in June only to start a steady decline going below 2.6% earlier this month. Monetary policy is a blunt weapon and can only really make a dent on cost-push inflationary pressures by driving the economy into recession, as we saw in the 1970s stagflationary era. The US bond market appears to be discounting just that. The Senate has recently passed the Inflation Reduction Act of 2022 with measures to curb inflation such as the lowering of prescription drug prices. In contrast, South Africa’s 10-year government bond yield rose from 9.4% in February to over 11.4% in July, only pulling back after SARB’s surprise 75 basis points hike last month. Despite the recent pull back to just below 10.65%, and excluding the blowout during the Covid crisis of 2020, we have to go back to the Global Financial Crisis of almost fourteen years ago to get to similar levels.

The primary role of most central banks is to ensure price stability in the economy. This is particularly important as inflation erodes first and foremost the purchasing power of the most vulnerable members of society. While the SARB has credibly anchored inflationary expectations in the 3-6% range for years, it appears that in the near term, monetary policy will remain constrained by a virtual policy arms race by the Fed to fight rampant inflation. This is unfortunately not good news for an economy yearning for growth and jobs.