Fed's attempts to accelerate inflation may result in severe crisis
CHICAGO – April 4, 2019
The Fed may create financial “bubbles” in an attempt to warm up inflation. The probability of such a development is quite large, analysts say.
Federal Reserve head Jerome Powell called low inflation one of the challenges of the time, and it looks like he wants to take up the challenge.
The Chicago Fed Index now indicates the mildest financial conditions since 1994, that is, all the conditions for accelerating the growth of prices are already there.
The Fed, in seeking to spur inflation, risks provoking the emergence of those "bubbles" of assets which Powell has associated the last two recessions with.
The Fed’s unexpected rejection of plans to raise the key interest rate this year pushed up stock prices, high-yield bonds, and other risky assets, despite investors' persistent concerns about a slowdown in global economic growth.
Financial conditions, at least according to the indicator of the Federal Reserve Bank of Chicago, are the mildest since 1994, and may well become even softer.
“If by the end of spring there will be a feeling that economic growth is gaining momentum, and the Fed keeps the rate unchanged, the markets will decide that the ideal scenario for them is again relevant, and this can warm up the appetite for risk,” believes former high-ranking Fed official and now chief economist at PGIM Fixed Income Nathan Sheets.
That puts the Fed in a difficult position. Announcing a cardinal turnaround last month, Powell stressed the regulator’s willingness to maintain price pressure and described low inflation as “one of the main challenges of our time.”
He left open the possibility that the next change in the Fed’s rate, which the regulator raised four times last year, could be a decrease.
However, the desire to revive inflation through low interest rates may ultimately jeopardize financial stability, triggering an excessive appetite for risk, says Allianz SE chief economic adviser Mohamed El-Erian.
This would be precisely those “destabilizing excesses” that, according to Powell, led to the last two economic downturns.
First there was the dot-com boom in the late 1990s, which ended in a collapse in stocks and led to the 2001 recession. Then there was the rise and fall of the housing market, before the most severe contraction of the economy since the Great Depression.
Now there really are prerequisites for inflating “bubbles,” but for now they are brewing only in the financial markets. In the real sector, there is nothing of the kind that happened during the dot-com bubble or the mortgage boom. However, perhaps we will see something like that again.