By Nikolaj Schmidt, chief international economist at T. Rowe Price
When central bank governors from around the world gather for the annual symposium hosted by the US Federal Reserve, few things are as usual. Inflation and wage increases are at problematically high levels, while at the same time, we see economic indicators pointing to a serious slowdown in the global economy. This puts US central bank chief Jerome Powell in the spotlight.
While central bankers can enjoy the view of the snowy peaks of the Rocky Mountains and discuss monetary policy and the economy, there are dark clouds for those who hope Powell leaves the revolver in the holster. From the Fed’s eyes, the current situation requires resolute action in the form of interest rate increases.
On the inflation side, there was good news a few weeks ago. Over the summer, lower oil prices have resulted in slightly lower inflation. The less good news is that although core inflation has also fallen, it is still at a high level. Measured on a monthly basis, core inflation is 3.8%. Nor does it get any better if a full 2.5 percentage points come from increases in housing costs. It is an inflation parameter that changes very slowly. Therefore, the expectation is inflation will still be high and above the inflation target for a long time to come.
When the latest job numbers came out a few weeks ago, it was not difficult to come up with a headline: ‘the American labour market is red hot’. A total of 528,000 new jobs were created in the month of July. If the unemployment rate, which is at a record low level, is to stabilise, it will require the creation of far less than 100,000 new jobs per month. We are very far from this, which is why wages were pushed up. On average, wages rose 5.8% in July. Wage increases at this level matches very poorly with the Fed’s inflation target.
Therefore, the conclusion is clear to me. Inflation is too high, and unless the labour market cools significantly, inflation will continue to deviate from target.
Powell and the Fed are therefore unlikely to welcome the recent easing of financial conditions. And in terms of monetary policy, there is only one thing to do – further tightening. This suggests we will see a combination of a weaker stock market, a widening of credit spreads, a stronger dollar and rising interest rates.
The Fed does not control financial conditions directly, but it has a very effective tool in the key interest rate. And there is no room to blink. Therefore, I expect we will see a central bank chair who will not only be ready to fire, but to send a volley of interest rate increases.
The timing is not lucky. Our best high-frequency temperature gauge for the world economy, the PMI numbers, say we are in a recessionary global economy. Therefore, the recent increases in the stock market look fragile. Take cover folks – we are in for a wild ride.
