The two days that could decide the fate of the global economy

Markets see it differently, pricing in a 5 percent peak rate for May or June next year, with US rates falling about 50 basis points in the second half of the year.

If the scatter chart produces a different scenario, it will provoke an unhappy reaction from investors, especially after the stock market rose on Monday in anticipation of further evidence that inflation has peaked and is trending down and that a less ‘hawkish’ The FOMC will set the tone.

US inflation appears to have peaked and some of the factors that propelled it to 40-year highs earlier this year in the US and elsewhere are easing.

Global supply chains are operating almost normally, helped by the global slowdown in economic activity.

The Fed and other central banks have been major contributors to the eruption of inflation with more than a decade of unconventional monetary policies that have kept interest rates close to zero and pumped enormous amounts of liquidity into the financial system.

This policy has now been reversed, with interest rates soaring and all major central banks withdrawing liquidity through “quantitative tightening” or expiring the hoards of bonds and other securities they had acquired during the quantitative easing period without allowing the proceeds reinvest.

Governments that began fiscal excesses in response to the pandemic have also scaled back spending.

An oil price that approached $130 a barrel earlier in the year, dragging gasoline prices with it, has slipped back below $78 a barrel.

The US dollar rose sharply against other major currencies earlier in the year, effectively increasing the cost of key resources and agricultural commodities for the rest of the world. In the meantime, it has fallen back to the level at the beginning of the year. It also eases some of the pressure on other central banks to raise interest rates to avoid US dollar-induced depreciation and capital outflows.

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Sliding towards recession

Having recovered from the worst of the pandemic, the global economy is now sliding towards recession. China, the main engine of global growth in recent decades, has stagnated due to the measures it has taken (now relaxed) to quell COVID outbreaks and its (largely ineffective) response to the implosion of its real estate sector.

Therefore, without the war in Ukraine, which sent international gas prices skyrocketing and could possibly trigger yet another rise in oil and other commodity prices, almost all of the main drivers of the great burst in inflation rates would be trending in the right direction – apart from the wage inflation.

Unless inflation data surprises, the Fed (and some other central banks, like our RBA) are entering a difficult period for monetary policy.

Conventional wisdom among central bankers is that they should aim for 2 percent inflation, a somewhat arbitrary target set by the Reserve Bank of New Zealand decades ago.

It is unlikely that the Fed could achieve 2% inflation next year without raising US interest rates significantly more than markets were expecting and without pushing the US economy into recession.

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It’s either postponing its target or giving longer thought to how to achieve it, capping the federal funds rate at about 5 percent but leaving it there longer than the market expects.

The bursts of wage inflation, particularly in the service sector, are a wild card.

For more than a decade, central bankers have been frustrated by the lack of inflation and meager real wage growth. Countless articles have been written on the subject, offering technology, demographics and a glut of global savings as potential explanatory threads.

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Now central bankers are concerned that wage inflation could spiral out of control, moving from pre-pandemic too little to post-pandemic too much.

That could argue for further significant rate hikes to trigger a sharp rise in what are now historically low unemployment rates in the US and other economies like Australia – and a central bank-managed plunge into recession.

The other unknowns that will influence interest rate decisions over the next year are recent changes in the global economic and geopolitical landscape.

The reshaping of global supply chains in the wake of the pandemic and in response to rising tensions between the West and China and Russia – “re-shoring”, “friend-shoring” and European efforts to eliminate the continent’s previous dependence on Russian energy – suggest that there will be new and solid inflationary pressures, at least in the medium term.

The Fed and its peers have made their current predicament more difficult than it could have been – and the post-pandemic environment would have been difficult regardless of what they did – by maintaining unconventional monetary policies well after the 2008 financial crisis . and by their responses and the similarly lavish responses of their governments to the pandemic.

Achieving a “soft landing” in these circumstances using only the crude tools of interest rates and liquidity has never been easy, and this proves it.

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