By Christopher Leonard
In August, central bankers and economic pundits from around the world descended on Jackson, Wyo., to hear the keynote speech at the Federal Reserve’s annual symposium. In the days afterward, the world’s smartest economic brains were all focused on trying to interpret the most important word from the speech: “pain.”
Fed Chair Jerome Powell was sending one clear message to global money managers: The Fed is deadly serious about reducing inflation, the bank won’t back off and the results are going to hurt. Specifically, Powell promised that the Fed will continue to hike interest rates and keep them elevated until the bank has brought inflation down from over 8 percent, where it is now, to the Fed’s target of about 2 percent. This week, the Fed is expected to announce another large increase at its regular policy meeting.
These steady increases will almost certainly mean higher unemployment and weaker economic growth until inflation is fully tamed, Powell emphasized. “These are the unfortunate costs of reducing inflation,” he continued. “But a failure to restore price stability would mean far greater pain.”
In case anyone didn’t get the message, Powell invoked the name of Paul Volcker, the legendary former Fed chair who doubled interest rates and killed inflation back in the late 1970s. Volcker is famous in central banking circles for doing the very hard thing that no one wants to do but that’s necessary to break an out-of-control inflation cycle. Volcker’s bitter medicine killed the economy, drove unemployment above 10 percent and ushered in the worst banking crisis since the Great Depression. But it also ended inflation after years of unsuccessful attempts by the federal government to do so using every tool from wage and price controls to public campaigns against spending.
Powell is right about one thing: It is difficult to anticipate just how much pain will be unleashed by the coming waves of interest rate increases.
But the Volcker comparison elides an important fact: Volcker had it easy, in many ways, compared to Powell. The American financial system today is far more fragile than the one Volcker inherited, mostly because of an economy the Fed has dramatically remade in recent decades.
Over the last decade, the Fed has undertaken an unprecedented experiment in ultra-low interest rates and easy money. Investors, bankers and governments have all adapted to that new economy, taking on more debt and pouring more money into riskier investments. Now, a decade’s worth of these debts and investments are going to collide with a higher-rate world. It’s not going to be pretty.
The worst damage will likely come in the parts of the financial system that the Fed has distorted the most over its past decade of easy money experiments: federal debt, corporate debt and sovereign debt. No one knows where we’re headed, exactly, but we do know how these key parts of the economy got to be so volatile in the first place. Here’s how — and why each of them is likely to bring huge shocks to the economy over the coming months or years of inflation reduction.
The Federal Reserve fed the national debt. Now, that debt is about to become a lot more expensive, straining the government and possibly roiling the global financial system.
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