The Federal Reserve will deliver a volatile summer for markets

America's central bank has hinted that it expects to raise interest rates twice in 2023, sending send markets into a spin. There's more volatility to come.

Has Jerome Powell turned into a hawk? The chair of the US Federal Reserve, America’s central bank, has repeatedly insisted that surging inflation is “transitory” and that monetary policy must be kept ultra-loose for the foreseeable future. The annual rate of US inflation hit a 13-year high of 5% last month, while other data also shows that the US economy is red-hot. Hence a rethink: last week Powell finally acknowledged that “inflation could turn out to be higher and more persistent than we expect”. 

The end of the reflation trade

Fed policymakers have signalled that they expect to raise interest rates twice in 2023, earlier than previously suggested. While that seems far off, the mere hint that the Fed is taking inflation more seriously was enough to send markets into a spin. 

America’s S&P 500 stock index had its worst week since February last week, tumbling by 1.9%. The last seven months in markets have been defined by the “reflation trade”, says The Economist. Vaccine-enabled reopening has brought greater interest in beaten-down consumer, financial and commodity stocks. The optimism was underpinned by “super-loose monetary policy”: US interest rates are close to zero and the Fed is making $120bn in monthly asset purchases, financed with quantitative easing (QE) – printed money. 

The suggestion that it “may eventually think about” hiking interest rates feels like a turning point to some. Stocks rallied again at the start of this week, suggesting the reaction was a bit overdone. The US economy has still not fully reopened; the “great reflation trade” could still have “further to run”.

Pick your poison: debt or inflation 

Central bank promises of future interest rate rises have a credibility problem. Policy makers “face a brutal choice”, says Jeremy Warner in The Daily Telegraph, Central bankers need to raise interest rates to control inflation, but doing so risks provoking a “fiscal and economic crisis”. Governments and firms loaded up on debt to get through the pandemic. Hiking their ultra-low borrowing costs could spell ruination. Policymakers will instead be forced to “let inflation rip”. This quandary is a reminder that the “response to any crisis ends up sowing the seeds for the next one”. Signs of future trouble are already brewing, says Irwin Stelzer in The Sunday Times. The US housing market is booming, with a pace of price increases unseen since before the 2007 subprime meltdown. Powell admits as much, so why on earth is the Fed still buying $40bn a month in mortgage-backed securities, a measure designed to prop up the market in the depths of the crisis? Economist Larry Summers thinks “future financial historians will be mystified”. 

Traditionally, financial markets “entered the doldrums” over summer as people went on holiday, says Randall Forsyth in Barron’s. But this year the Fed faces the delicate task of unwinding its “supereasy monetary policies”. Attempts to “taper” monetary support have brought market turmoil in the past. Investors should “prepare for a volatile summer”.

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