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With rate hikes, Fed creates deflation risk

09/12/2022
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While the Fed Chairman seems to hint that the policy of rate hikes will continue, many warn about deflation risks in the US.

Fed Chairman generates deflation risk

The Fed seems intent on not backing off an inch on its aggressive policy to counter the record rise in inflation, which has hit 9% in the US. In a recent speech in Jackson Hole, Chairman Jerome Powell made it clear that the policy of raising rates will continue until inflation returns to acceptable levels.

“The longer inflation remains high, the more of a problem it will be,” said the Federal Reserve’s number one man in Wyoming, and then said that the Fed will “vigorously” use the tools at its disposal in order to continue to combat the flare-up in US prices. As if to say that the two consecutive 0.75% hikes in US rates will certainly not be the last. However, at the same time, Powell also admitted that this rate policy may have negative impacts on the economy and people’s pockets.

In this regard, Powell stated that:

“While higher interest rates, slower growth and more flexible labor market conditions will bring down inflation, there will also be a negative impact on the pockets of households and businesses,” Powell said. “These are. the unfortunate costs of reducing inflation. But a failure to restore price stability would be even worse for the economy.”

In short, the Fed thinks that despite the fact that there are risks on economic recovery from a steady and robust rise in the cost of money, not vigorously countering the rise in inflation could have even worse effects. Many economists and experts think this could even cause recessionary effects on the economy, which is recovering but has to contend with a general situation that is far from easy. 

The concerns of Elon Musk and Cathie Wood

Some people, like Tesla founder Elon Musk, go even further, pointing out that an excessive rate hike could also have deflationary effects on the economy.

Musk’s warning came after an analysis by Ark Invest CEO Cathie Wood, who warned:

“Leading inflation indicators like gold and copper are flagging the risk of deflation.”

According to Wood, the US economy would already be in recession, despite the fact that economic data would seem to disprove this claim for now. According to the CEO of Ark Invest, the problem after inflation would now be its exact opposite, namely deflation, as she argued in an interview with CNBC:

“We were wrong on one thing and that was inflation being as sustained as it has been,” Wood said. “Supply chain … Can’t believe it’s taking more than two years and Russia’s invasion of Ukraine of course we couldn’t have seen that. Inflation has been a bigger problem but it has set us up for deflation.”

What Wood argues, like many other economists, is that the Fed got it wrong twice. First, it would have waited too long before intervening to counter the mighty rises in inflation in recent months, and next it would now have intervened too drastically. It is no coincidence that after the Fed Chairman’s Jackson Hole speech the markets reacted with widespread declines on all the major stock markets.

Many members of Congress, including Senator Elizabeth Warren, sharply criticized this policy, saying that this attitude on the part of the central bank could lead the star-studded economy toward a probable recession.

In August, Musk said he was convinced that inflation would have peaked by now, indicating that the Fed might take a less aggressive stance, and would begin its descent, which might lead to deflation and a subsequent 18-month recession.

Current levels of inflation in the US and Europe

The latest data in regard to US inflation have actually recorded an apparent halt in price increases in America. And that is why Powell’s speech surprised those who thought that the central bank would now at least take a more wait-and-see attitude toward monetary policy in order to keep inflation at bay, which still remains above 8%. 

On the other hand, the US economy, and the European one, come from years of very expansionary policy by Central Banks, which while it has certainly had positive effects on the economy, it has also led to long-term distortions and speculation that are now exploding with record rises in commodities, energy and prices in general.

Recently, the ECB also made a robust 0.50% rate hike to combat inflation that is spiking even higher than in the US, by more than 9%. But even this belated European intervention, could have even worse effects than in the US on economic recovery. The old continent also has to deal with a monstrous rise in energy costs, exacerbated by the outbreak of the conflict, and an economy that is showing mixed signals, with Europe’s locomotive, Germany, showing clear signs of an economic slowdown, which some say, could soon lead to recession.

The problem of inflation has always been a priority for the European Central Bank, which it has followed as a mantra in recent years, considering a fair rate to be that of 2% (a figure that makes one smile when thinking of current rates). But the 2008 financial crisis and the current pandemic, with subsequent recessions in Europe and sovereign debt crises, have led to an inevitable easing of measures by the ECB and the Fed.

The risk of a recession lasting too long

Now, however, the risk is that too much time has been waited, and that too sudden and robust interventions may actually have the opposite effect and send the US and European economies into a kind of vicious cycle that could have devastating effects on the weaker sections of the population.

As all political economy texts explain, when an economy is heavily loaded with debt, as the American and European economies are at the moment, due to the continuous expansion of the supply of credit, when this supply falls abruptly due to a rate hike such as the one operated by the Fed and ECB, asset prices fall and excessive speculative investments are liquidated. This results in so-called debt deflation, which seems to be precisely the condition toward which we are heading.

Source: https://en.cryptonomist.ch/2022/09/12/rate-fed-creates-deflation-risk/