Challenges ahead for the Fed and policymakers

Published: Jul 2022

Consumers, many economists, banks and asset managers have become distinctly more pessimistic about the US economy as the Fed closes the money tap, wide open for many years. The White House has desperately launched an offensive via a wide media palette to assure the public that “a recession is not inevitable,” in the words of Joe Biden himself. It doesn’t come across very convincingly.

America has been on the central bank’s drip for years. This has kept the economy going, and in particular the asset markets: shares, property, cryptos, etc soared to exceedingly high levels. The economy was manipulated in such a way that Wall Street and Main Street ended up increasingly detached from each other. As Financial Times columnist Rana Foroohar phrased it: “Since the end of the Bretton Woods system in 1971, policymakers from both sides of the aisle, Democrats and Republicans, have been able to shift the tough process of what we might call guns and butter decisions.”

For the Fed – with its dual mandate of keeping inflation in check and maintaining employment levels – it was relatively easy to keep the party going due to decades of structural downward forces on inflation. However, supply side problems – caused by corona and subsequently by the Ukraine war – threw a spanner in the works; it was no longer possible to have it both ways: holding inflation low and, at the same time, being able to keep pumping dollars into the economy.

Many experts have long been warning about the risks of the imbalance between the real and the financial economy with, among other factors, sky-high stock valuations, lagging productivity, enormous debt piles, skewed rises in income and relatively low growth. Additional effects included work being far less profitable than investment, and companies sometimes making more money playing asset manager than manufacturing products or providing services that actually form the core of the business. In 2017, the Wall Street Journal was already joking that Harvard is a hedge fund that happens to have a university.

This model has entered the danger zone because inflation has risen rapidly. The Fed will have to turn the music down, limit alcohol sales and remove the garlands because the party has come to an end. Central banks – and not just the Fed – have long almost begged policymakers to jump through the window of opportunity for structural reforms afforded by monetary policy in order to make economies more resilient and productive, but these pleas have generally fallen on deaf ears. With inflation rampant, there is little that the Fed can do to keep the US economy running (in a sustainable manner); it is up to policymakers to rise to the occasion.

The Biden administration’s top priority is taming inflation. Exploding petrol prices in particular have been a thorn in the side of the White House. Record prices have been on the front pages all the time and have increased the already high likelihood of the Democrats being crushed in the midterm elections in November. Unfortunately for Biden and his party, there are few adequate tools available to rein in prices at the pump without unpleasant side effects. For example, waiving the excise duty on petrol and diesel makes for a nice PR moment, but such a measure offers temporary relief at best – if at all – and it entails drawbacks:

  • A reduction in the price will boost demand for a product that is already very scarce.
  • A reduction in excise duty is a very generic tool in the sense that it is the biggest fuel consumers who benefit the most. These are usually people who are generally already well off and do not necessarily need the reductions.
  • The excise duties on fuel are used to fill an infrastructure fund. American roads are definitely not the best, so they could use every extra dollar for improvement.

Other measures to lower fuel prices or to prevent further increases are also not ideal. For example, a form of export controls would further exacerbate already existing fears of a new era of protectionism. If it were to trigger a chain reaction, it could prove to be counterproductive.

The administration has also been considering other options to alleviate financial burdens on households. For example, by lowering tariffs on Chinese imports. However, even economists within the administration believe it might only shave a quarter of a percentage point off inflation. Moreover, such a decision would come at a sensitive time, with escalating tensions between the US and China in several important areas.

Biden has limited scope to pass major measures to boost the economy and/or curb inflation. His Build Back Better plans have largely floundered, and little can be done for the housing market in the period ahead. The political clout is likely to diminish further following the midterms in November. Everything points to defeat for the Democrats, which will severely restrict Biden’s scope for manoeuvring during the second part of his term.

In addition, Trump is still considering stepping back into the ring in 2024. His first round in the political arena did not result in a self-inflicted knockout for America but as Democratic Representative Adam Schiff said during the Capitol storming hearings: “The system held, but barely.”

The most striking aspect so far, is that very few Republicans openly abandon Trump (and those who do have often become pariahs within their own party). This is not even that surprising, as a very large proportion of Republican voters still believe Biden stole the election. Moreover, the Trumpists are doing quite well so far in the run-up to the midterms.

All this points to an uncertain political climate in the coming years, in which economic reforms are likely to be very slow in getting off the ground, and in which American democracy will come under even more pressure. Already, the US has been a flawed democracy for more than half a decade on the Democracy Index by the Economist Intelligence Unit. Last year, the US achieved the lowest score since the first publication in 2006.

The above led us to the following expectations:

  • The previously quoted Foroohar recently said: “The Fed can’t do what policymakers can do, it can’t change the story on Main Street. It can’t build a new factory. It can’t re-skill all of us to do better jobs that are higher up the food chain.” However, policymakers also fail here. This points to persistent low growth, if not a recession.
  • The likelihood of a fiscal stimulus package seems low. First of all, there is broad consensus that the last major package has contributed to the current excessively high inflation. Secondly, Republicans will not allow Biden a victory in the run-up to the midterms. And thirdly, debts are soaring, and it will prove increasingly hard to sustain them as interest rates rise to higher levels.
  • The strong dollar will now be regarded mainly as something positive, as it depresses inflation because imports are cheaper. This is why we do not expect any attempts to devalue the dollar. But keep in mind, this inflation-depressing impact of the strong dollar is relatively low, as imports expressed as a percentage of US GDP only amount to 13%.
  • Two-thirds of Americans own their own home and the percentage of Americans owning shares and other assets has increased tremendously. The Fed, and especially politicians, will be very wary of pulling the tablecloth from under the crockery of this vast number of voters. This is why we certainly do not rule out that the central bank, the White House and Congress will still pull out all the stops if the stock and/or housing markets decline considerably (further). However, this will only make the foundations of the US economy more brittle, and one day things will have to get back into balance. The decoupling of the real economy and financial markets will undergo a correction at some point. To quote Faroohar one last time: “Once Main Street starts to meet Wall Street, you’re going to get that asset price correction. It’s going to be painful.”

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